Powell must disregard Kudlow’s loose policy siren song

On Tuesday and Wednesday next week, Jerome Powell will chair his first Federal Reserve interest-rate-setting meeting. He will do so at a time that Larry Kudlow, President Trump’s newly appointed head of the National Economic Council, is urging the Fed to let the economy rip by keeping interest rates low.

For the sake of the country’s long run economic prosperity, Powell would do well to disregard Kudlow’s advice. Instead, right from the get-go, he should assert the Fed’s independence in the pursuit of its dual mandate of seeking price stability and maximum employment.

{mosads}He should do so by resisting political pressure for maintaining low interest rates and by committing the Fed to a faster pace of interest rate hikes than was the case under Janet Yellen’s Fed.

There are several compelling reasons that would argue in favor of an early tightening of monetary policy. Among those are the fact that at a time that the economy is at, or perhaps even beyond, full employment, inflation is starting to accelerate and inflationary expectations are rising.

One would think that it must be a matter of serious concern for the Fed that over the past six months, core consumer price inflation (which excludes volatile energy and food prices) has been running at an annual 2.5 percent rate.

More disturbing yet, long-run inflationary expectations, as measured by the five-year, break-even bond levels, are now in excess of the Fed’s 2-percent inflation target.

Another reason arguing in favor of a more rapid pace of interest rate hikes is that the economy is now growing at a faster rate than its potential, and it is receiving excessive policy stimulus for this late stage in the business cycle. This runs the risk of having the economy overheat and of thereby having the Fed lose control over inflation. 

One source of ill-timed policy stimulus that the economy is now receiving comes from the unfunded Trump tax cut, which is estimated by the Congressional Budget Office to add $1.5 trillion to the budget deficit over the next decade.

In addition, there is Congress’ recently approved $300 billion public spending boost over the next two years. The IMF estimates that these tax cuts and spending increases will boost the economy by around 0.75 percent of GDP in both 2018 and 2019 at precisely the time when the economy does not need such stimulus. 

Yet another source of excessive stimulus that the economy is now receiving comes from the substantial loosening in financial conditions over the past year. Courtesy of very low Fed interest rates, since the start of 2017, U.S. equity prices have increased by around 25 percent and home prices by 6 percent.

European stock markets have turned lower as investors look nervously to Jay Powell’s first meeting as head of the US Federal Reserve. Hear is the latest: https://t.co/f0yrOwkIaN pic.twitter.com/NtQvj01Yaf

— Financial Times (@FinancialTimes) March 19, 2018

This has resulted in an $8-trillion increase in U.S. household wealth that makes households more likely to increase consumption. Over the same period, there has been around a 10-percent dollar depreciation that is giving a big boost to the U.S. export sector.

Perhaps an even more compelling reason why Powell should disregard Larry Kudlow’s siren call for low interest rates is that by heeding that call, he risks further inflating the asset price and credit market bubbles that are already all too much in evidence around the globe. In that process, he would be setting us up for another damaging boom-bust cycle. 

Already we have global equity valuations at lofty levels seen only three time before in the past 100 years, credit markets with interest rates at artificially compressed levels that do not adequately compensate for risk, and housing market bubbles in a number of key economies.

If ever there was a time for the Fed to be removing the punchbowl, it has to be now when the asset price party is in full swing. 

Many past episodes of U.S. monetary policy history teach us that once the Fed loses credibility as a guardian of price stability, it is very difficult for it to regain that credibility. At the same time, the 2008 Lehman crisis experience should have taught us that asset and credit market bubbles are highly damaging to long-run economic prosperity.

For those reasons, we have to hope that at his first meeting as Fed chair, Powell stands firm and resists pressure from the Trump White House for the continuation of an inappropriately loose monetary policy stance.  

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.