The economic consequences of Jerome Powell

William McChesney Martin famously observed that the Federal Reserve’s job was to remove the punchbowl when the party gets going. Judging by his recent behavior, it seems current Fed Chair Jerome Powell does not subscribe to Martin’s view. 

Last year, when the economy was booming and the equity and housing market were on fire, the Powell Fed maintained an ultra-easy monetary policy stance. Last week, with consumer price inflation running at a hairbreadth below 8 percent, the Fed chose to raise its policy rate by a measly 0.25 percentage point. That leaves its interest rate at an inappropriately negative level in inflation-adjusted terms at a time of high inflation. 

Especially after Russia’s invasion of Ukraine and the renewed Chinese COVID-19 outbreak, the Fed’s timidity with interest rate increases likely means that we will have to learn to live with a prolonged period of high inflation. It also means that we should brace ourselves for a nasty economic recession when the Fed is eventually forced to raise interest rates aggressively to get the inflation genie back into the bottle.

Even before Russia’s Ukraine invasion and China’s new COVID outbreak, the U.S. economy was dealing with an inflationary and financial market mess. 

Last year, the Fed kept interest rates too low for too long and allowed the broad money supply to increase at its fastest pace in 50 years. It did so as the economy was already recovering strongly and had received an historic $5 trillion in budget stimulus. It also continued to buy large amounts of Treasury bonds and mortgage-backed securities at the same time that U.S. equity valuations had reached nosebleed levels recorded only once before in the last 100 years and as housing prices were increasing by close to 20 percent a year.

As bad as inflation has been, though, Russia’s invasion of Ukraine will surely propel it even higher on the back of rising prices for energy, grains and metals, all of which Russia is a major world supplier. China’s recent COVID-related lockdown of several major cities could boost inflation even higher by further disrupting the global supply chain. Such a disruption would be especially painful for Apple and other high-tech companies that are very dependent on China for key industrial components. 

The Powell Fed’s past recklessness in both allowing inflation to rise to its fastest pace since 1982 and creating an equity, housing and credit market bubble has put it on the horns of a very difficult policy dilemma.

If it raises interest rates too aggressively, it might succeed in taming inflation, but it would do so at the risk of bursting the asset price and credit market bubbles. That, in turn, could precipitate an economic recession by wiping out household wealth and by causing strains in the financial system as occurred following the September 2008 Lehman bankruptcy.

On the other hand, if the Fed doesn’t raise interest rates aggressively enough, it might help stabilize the financial markets, but it could risk losing control over inflation. And that would set us up for an even deeper economic recession, since the Fed would eventually be forced to raise interest rates sharply to prevent inflationary expectations from spinning out of control.

Last week’s Fed policy meeting would suggest that the Fed is continuing to take unwarranted risks with inflation by opting for policy timidity. Instead of taking the inflation bull by the horns, the Fed is choosing to fight inflation with small 25 basis point interest rate increases at its scheduled meetings this year. It is difficult to see how such small interest rate increases will make a dent in inflation considering that they will leave interest rates well below the expected inflation rate.

In the early 1980s, when inflation was last out of control, then-Fed Chair Paul Volcker had the courage to raise interest rates from 11 percent to 20 percent to successfully slay the inflationary dragon. The Powell Fed’s timidity in addressing today’s unacceptably high inflation rate must be making Volcker roll over in his grave.

Desmond Lachman is a senior 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.