The Fed’s dilemma

Does the Fed tighten purely for ‘financial stability’ reasons or does lowflation keep them at bay. That’s the dilemma facing the new Fed Chairman Jerome Powell. And it’s not an easy one to solve.

Here’s how Gary Shilling puts it:

With the pickup in global economic growth, central banks — except for Japan’s — are shifting to tightening from extremely easy money, including massive quantitative easing and trivial, if not negative, short-term interest rates. The Federal Reserve has raised its target for the federal funds rate five times since December 2015 and is suggesting three more increases this year.

But the Fed is confronted with a serious dilemma: Inflation and wage increases continue to undershoot its expectations at the same time the central bank confronts forces pressuring it toward credit tightening. 

The new chairman, Jerome Powell, who isn’t a trained economist, may change the central bank’s tone, but his soon-to-be predecessor Janet Yellen and the other academic economists who have dominated monetary policy, believe fervently in the theoretical Phillips Curve. It posits that a declining unemployment rate should spur inflation, despite evidence to the contrary. Rather than increase as the unemployment rate declined since the recession, the rate of inflation has largely stayed the same.

My take: I know one Fed President thinks that raising rates due to financial stability concerns is the wrong way. He says evidence suggests that “if central bankers were to try to use monetary policy to slow those bubbles down, the rate increases necessary to be effective would likely be large, resulting in high economic cost to the rest of the economy.” But I think this is a minority view.

Powell mentioned financial stability as a concern as he was sworn in today. With markets taking a dive, it’s not clear what that will mean in terms of policy. But in terms of causation, I think it’s the market’s realization that the Fed will hew to its timetable — with a clear risk of more hikes — that is causing markets to fall.

More from Gary Shilling on this here. He cautions that “if an inverted yield curve occurs, it may not, as in the past, guarantee a nearby recession, and it may take years before Fed tightening precipitates one.”

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