Daniel Lacalle

Yellen’s Poor Legacy and Powell’s Challenges

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Powell faces a complex mandate with the Federal Reserve balance sheet at exceedingly high levels and too low rates despite growth, jobs and inflation accelerating

The appointment of Jerome Powell as the new chair of the Federal Reserve must be interpreted by the markets as a sign of continuity. He is not the hawk that many market participants feared and neither holds a dovish and dangerous stance.

Yellen’s mandate has been widely criticized by many investors and economists. She inherited an economy where unemployment was at the Fed’s target levels, inflation was picking up and growth was strengthening, and yet she unnecessarily delayed raising rates and reducing the balance sheet for too long.  The president’s confidence, despite nice words, was broken for months. The Trump team criticized the Federal Reserve for delaying the announced rate hikes ahead of the elections, but criticism intensified when Yellen raised cautionary messages about the economy after the nomination. Considered an “acknowledged dove”, she was criticized for delaying much-needed rate hikes, despite markets at all-time highs, yields at multi-decade lows, inflation rising and unemployment at 5%, and some hinted this was an “order” from the Obama administration. Now that we see that the latest figures show a growth of 3% of the US economy, the critical voices have increased, accusing the now ex-president of the Federal Reserve of being unnecessarily dovish, ignoring the mounting risks in financial markets and not getting the diagnosis right.

Yellen’s legacy is indeed poor. The Federal Reserve, under her mandate, has consistently lagged behind the curve by more than 250 basis points. It has also been very poor when it comes to analyzing the US economy, underestimating inflation, jobs, and growth. Fundamentally, she has been accused of simply perpetuating the measures taken by Bernanke and avoiding taking decisive action to curb extreme complacency in financial markets.

Yellen also overestimated the strength of the job market, ignoring why real wages did not rise despite low unemployment, and completely underestimated the abrupt rise in housing prices. More importantly, she never commented on the rising problem of government spending and debt, increases in taxes and regulation and the negative impact of these factors on key aspects of the economy, particularly wages and investment.

Yellen’s mandate can be summarized in two words: missed opportunity.  She arrived when the economy was already healed and growing, and failed to identify the burdens on growth created by excessive debt and taxes. More importantly, she had a fantastic window of opportunity to reduce the $4.5 trillion balance sheet of the Federal Reserve when markets were soaring, and raise rates closer to the inflation level, and decided not to do it, missing a critical window of opportunity.

Jay Powell is not a real change from the previous Federal reserve chairs. He is a clear follower of the same policies that Greenspan, Bernanke, and Yellen have carried out, which is to lean on remaining accommodative. He is a strong advocate of private initiative, which is why he seems to be cautious when thinking of raising rates, paying attention to the possible impact on companies. However, he is known to be critical of the massive purchase of government bonds because they encourage excessive public spending. He is also known to be critical of excess debt, while at the same time a less political person than other predecessors.

What markets, therefore, should expect, is a continuity in policy but closer to the thesis of the Republican party: moderation in rate hikes but less aggressive monetary policy. Powell has never denied the bubble of financial assets that can increase if the ultra-expansive policy is perpetuated.

Powell’s challenge is threefold. Recover rates closer to the reality of inflation and the market, monitor the risks of excess complacency and, at the same time, give clear messages that encourage investment in the US, and support growth.

It will not be easy. Powell receives a complex mandate with an exeedingly high balance sheet at the Federal Reserve, a tepid and insufficient reduction pipeline, and with the very low rates in spite of a healthy and growing economy. He is the first president of the Federal Reserve that arrives with rates and the balance sheet at such aggressive levels that he will not be able to take “expansive” measures in face of a specific problem. That is, as Yellen delayed the normalization as much as she could and more, she has passed the “hot potato” to Powell leaving him without relevant tools to combat a possible recession or imbalances that may appear in the future. If the US faces a recessive period or a crisis, Powell has been left in command without weapons or shields.

The markets have reacted to the appointment for what it is, more continuity But the question is, what will Powell do with a Federal Reserve without tools if a cycle change occurs?

Daniel Lacalle is Chief Economist at Tressis, SV a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat (Wiley) and Escape from the Central Bank Trap (BEP)

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