Homer’s Odysseus navigated successfully the dangerous straits between Scylla and Charybdis. It remains to be seen how successful present day Federal Reserve Chairman Jay Powell will be in navigating the dangerous straits in which the U.S. economy now finds itself.
His yet-to-be-tested skill at the Fed’s helm will be a key determinant for both the U.S. and the global economic outlooks in the year immediately ahead.
{mosads}It would be a gross understatement to say that Powell has inherited from former Chairwoman Janet Yellen a very difficult economic situation to manage.
Years of low interest rates and massive Fed bond buying, which saw an increase in the Fed’s balance sheet from $800 billion in 2008 to around $4.5 trillion at present, did succeed in returning the U.S. economy to close to full employment.
However, along with similar massive bond buying programs by the Bank of England, the European Central Bank and the Bank of Japan, it has also created a global asset bubble of major proportions.
Compounding Powell’s challenge is how pervasive today’s global asset price bubble is. Whereas in 2008, the asset price bubble was largely confined to the U.S. housing and credit markets, today’s bubbles are to be found in all too many asset markets around the world.
As former Federal Reserve Chairman Alan Greenspan recently warned, years of highly unorthodox monetary policy by the world’s major central banks have created a global government bond bubble, with long-term interest rates plumbing historically low levels.
He might have added that this bubble has hardly been confined to the sovereign bond market. Indeed, global stock values are at lofty heights that have been reached only three times in the last century.
At the same time, housing bubbles are all too evident in key countries like Australia, Britain, Canada and China, while interest rates have been driven down to unusually low levels for high-yield debt and emerging-market corporate debt.
Past experience suggests that asset price bubbles tend to burst when the central banks start raising interest rates. It also suggests that when major asset price bubbles burst, they tend to stress the financial system, which in turn can lead to a marked economic downturn.
To paraphrase Warren Buffet, when the liquidity tide turns out, we will find out which financial institutions have been swimming naked. We will also find out how interconnected the global financial system remains.
The emergence of an asset price bubble at a time that the economy is close to full employment presents Powell with an unenviable policy dilemma. If he has the Fed raising interest rates too quickly, he risks bursting the bubble.
If on the other hand, he does not raise interest rate sufficiently quickly, he risks both further inflating the bubble and inviting a return of inflation to the U.S. economy.
It would seem that the inflation risk is not to be underestimated. While to be sure, inflation is currently lower than most economists would have expected, the conditions seem to be in place for inflation to return.
Unemployment is now down to very low levels, and the economy is humming along at a good clip. The economy would now also seem to be getting an important boost from the powerful combination of still abnormally low interest rates, the 25-percent increase in stock prices since the start of the year and the president’s large, unfunded tax cut.
Hopefully, like Odysseus before him, Powell will have the skill to steer the U.S. economy through the difficult straits in which it now finds itself. If he does not, we should brace ourselves for some very rough sailing in both the U.S. and the global economies in the year immediately ahead.
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.