The stockmarkets took a real rollercoaster ride the week of February 5, with the Dow Jones plummeting more than 1,100 points in a single day’s trading on February 5, the most severe decline in its history in number of points, although only 4.6% in relative terms as compared to the 22.6% crash on October 19, 1987.
The index shed a further 1,000 on February 8. US indices had put in spectacular rallies since the start of the year and their growth was not sustainable, so a change in trend was inevitable.
However, this market shift remains a clear sign from investors, and comes just as the Fed undergoes a change in leadership. Janet Yellen took her final bow on the evening of February 2 and Jerome Powell was sworn in on February 5. Market losses and the change in leadership at the Fed are connected: the US central bank is very powerful and the choices it makes over the months ahead will be crucial for both the US economy and market performances.
And this is the crux of the matter. The new Fed Chair will have to find an answer to today’s very complex US economic equation, providing fresh impetus as he sets the course policy will take. He is obviously advised by a number of specialists, but when all is said and done, it is Powell who will dictate monetary policy, so his role is decisive, yet we may well raise questions on his monetary policy experience.
Janet Yellen succeeded in cutting back unemployment from 6.7% in February 2014 to 4.1% in January 2018, all the while managing to avoid creating any particular tension in the US economy and particularly without nominal pressures. Growth was admittedly not the fastest in the country’s recent history but it did not trigger any major imbalances. With Yellen at the helm, the Fed successfully steered the US economy.
Now it is Powell’s turn to take over and things are going to be very different.
He faces five challenges that will test his ability to keep the economy on a sustainable course.
The first two challenges are related to monetary policy normalization.
The Fed began its monetary policy accommodation in December 2008, firstly by cutting back its Fed funds rate to 0% then by carrying out extensive asset purchase programs. Yet Janet Yellen started to reverse this trend in December 2015, as she gradually upped the Fed funds rate, from 0.125% (mid range) to 1.375% currently and embarked on balance sheet rundown in October 2017.
These two initiatives are still tricky.
The first is difficult as there are actually no real imbalances in the economy. Rate hikes are not intended to correct an unwanted situation but rather serve to give the central bank the wherewithal to act in the event of a shock on the economy and the markets.
At current levels, we can well imagine that there is still some way to go and this was a key factor behind the financial markets’ recent tumble. In its latest press release, the Fed pointed to a slight acceleration in inflation towards 2%. At the same time, growth projections are strong at least for the start of the year (5.4% annualized for the first quarter of 2018 based on the Atlanta Fed’s model). So swift monetary policy normalization can therefore look perfectly normal. But just what rate hike path will the new Chair take? And how will he steer communication? We don’t have the answers to these questions, except for some wishful thinking that nothing will change, which is unlikely.
Meanwhile, looking to the second question of the balance sheet unwind, things seems well organized but the Fed’s roll-off is set to shift the balance on the US bond market. When things get out of control, the Fed needs to be able to act swiftly and efficiently to avoid a knock-on effect on the economy.
The third challenge will be communication. Bernanke and Yellen took the path of clear transparency as they sought to avoid surprising investors: observers all knew when the Fed was going to change its interest rates. The dot plot, when each member of the FOMC issues Fed funds projections for each year over the coming three to four years, embodies this transparency, but will this system be maintained or will the new Chair bring back more uncertainty by eliminating this famous plot? If the economic cycle recovers a degree of normality, this would be a rational move, as before the 2007 crisis.
The fourth challenge will be cushioning the shock from White House and Congress fiscal policy. Tax is set to drop significantly in the short term, with a procyclic impact over the months ahead as growth is poised to move up a gear. The difficulty for Powell is that monetary policy is still accommodative despite the start to normalization.
Is it a good idea for the US economy running on full employment to revive growth? Most certainly not. The Fed must be more restrictive than the path it set out during its last monetary policy meeting. This is a major source of concern. In order to be more stringent, the Fed must quickly adopt a restrictive approach to offset the overly accommodative policy coming out of the White House.
Meanwhile, the public deficit is set to soar. When the economy is running on full employment, is it wise to extend the budget deficit on a long-term basis (from less than 3% of GDP to an expected figure of 5-7% of GDP)?
This is set to trigger a long-lasting imbalance in the economy, which Janet Yellen had managed to avoid.
How will Jay Powell manage this situation? This is a real challenge, as the White House is deliberately creating an untenable situation for the Fed at this stage in the economic cycle, as it seeks to redistribute wealth to the wealthy.
The fifth and final challenge is that the stockmarkets are still very pricey. The Standard and Poor’s 500 is still trading on P/E (Price-to-Earnings ratio) of above 21x according to Bloomberg, despite corrections witnessed this week. What would the Fed do if the markets were to take a bigger hit than we have seen this week and similar to the 1987 crash? The central bank’s leeway is very narrow: the usual solution of slashing interest rates would not have its usual effect of calming the markets as the Fed Funds rate is already 1.375% mid range, so a massive cut is impossible. The Fed and its Chair will have to be come up with a smart solution that reassures investors and puts paid to the market decline.
Powell has a mammoth task ahead. He is going to have to manage monetary policy normalization against a backdrop of very expansionary fiscal policy in the short term and with an economy running on full employment. This is a difficult equation to solve, and we can fully understand investors’ concerns. But it is not necessarily Powell’s abilities that are in question, but rather the logic behind the White House’s policy, which is creating long-term imbalances in the US economy and wiping out Bernanke’s and Yellen’s combined efforts just to benefit a small few.
Philippe Waechter - Chief Economist - Natixis Asset Management