The Federal Reserve uses monetary policy to achieve two statutory mandates: maximum employment and price stability. It is a huge ask, as both employment and inflation are influenced by factors beyond the control of and, at times, beyond even the influence of monetary policy. Yet, over the last four years, the Janet Yellen-led Fed has very nearly achieved both objectives: the economy as a whole is at or near maximum employment, and inflation (and, importantly, inflation expectations) seems well under control, even if a bit shy of the Fed’s official target of 2%.
One could be forgiven for thinking incoming Fed Chair Jerome Powell has the easiest job in Washington. He simply needs to do what Chair Yellen did. Easy, right?
The task facing Jay Powell is, however, quite formidable and starkly different than that facing Chair Yellen when she first took the reins in January, 2014. Much of the market gains over the last several years (as well as the economic expansion, however tepid) have been made possible by the Fed’s aggressive and sustained loose monetary policy. Now the shift from Quantitative Easing to Quantitative Tightening has now begun in earnest, and this phase has historically been fraught with peril. Powell will almost certainly have a much tougher run than Chair Yellen.
Over the last 60+ years, each recession, as represented by the gray bars in the chart below (courtesy of the Federal Reserve Bank of St. Louis), has been preceded by Federal Reserve interest rate hikes. We call these periods of rising interest rates “tightening cycles”, and the central bank engages in these activities in order to prevent the inflation and financial imbalances that can come with rapid economic expansion. It is important to note that not every tightening cycle was following by a recession. I can identify four periods in the chart below in which rising interest rates were not followed by a recession. But again, each and every one of the nine recessions during this period was preceded by rising interest rates. It seems pretty clear to me that sustaining an economic recovery and extending an aging bull market, all while avoiding the pitfalls of rapid growth, will not be an easy thing to do.
Source: Federal Reserve Bank of St. Louis
Our view is and has been that the Fed should have begun the process of rate normalizing several years ago. Sustained low interest rates have pulled forward demand, created frothy asset prices, exacerbated economic inequality, and led to many other financial imbalances. These side effects will be difficult for the new Fed Chair to navigate. Having said that, we think Powell is the man for the job. He is pragmatic, backs his decision-making with data and sound rationale, and will adjust to realities on the ground. The question is, will those realities be too much to overcome for even the most qualified Fed Chair. Time will tell.