Jerome Powell’s own poisoned chalice

In 2006, when Ben Bernanke was chosen to replace Alan Greenspan as head of the Federal Reserve, The Economist magazine ran a memorable cover. It depicted Greenspan and Bernanke in a relay race, with Greenspan passing Bernanke a baton that was actually a stick of dynamite representing the economy. That cover turned out to be prescient, and the world soon succumbed to the Great Recession.

Although President Biden has nominated Jerome Powell to a second term as Federal Reserve chair, one could apply the same metaphor to Powell’s second term. But instead of handing a baton of dynamite to his successor, Powell has likely handed it to himself. 

There are two reasons for thinking that Powell has dealt himself an exceedingly challenging second term as Fed chair.

First, Powell’s excessively aggressive monetary policy response to the pandemic, at the very time that the country was receiving its largest peacetime budget stimulus, has contributed to the country’s highest inflation in the past 30 years. Indeed, consumer price inflation is now running at over 6 percent, well in excess of the Fed’s 2 percent inflation target. That in turn is making inflation-adjusted interest rates significantly negative in real terms, which risks allowing today’s uncomfortably high inflation to become entrenched.

Second, Powell, along with the world’s other major central bankers, has created a global asset price and credit market bubble of epic proportions. He has done so by aggressively buying U.S. Treasury and mortgage-backed securities. It took Bernanke’s Fed six years to increase the size of the Fed’s balance sheet by some $4 trillion; it took the Powell Fed less than a year to do the same thing.

As a consequence, U.S. equity valuations are at lofty levels experienced only once before in the past 100 years, and U.S. housing prices even in inflation-adjusted terms are now significantly higher than their 2006 peak. In addition, borrowers of questionable creditworthiness both at home and in the emerging market economies have borrowed vast amounts of money at low interest rates that hardly compensate for the risk of default.

All of this will put Powell in an unenviable position as he begins his second term. If he chooses not to raise interest rates soon to levels that are significantly positive in inflation-adjusted terms, he would risk allowing inflation to become entrenched, if not to accelerate. That in turn would set up the economy for a particularly hard landing when he is eventually forced to slam on the monetary policy brakes to restrain inflation.

Alternatively, if Powell were to raise interest rates early, as would seem to be the right thing to do in today’s inflationary environment, he would risk bursting today’s asset price and credit market bubbles. That would almost certainly invite sharp criticism, especially in the run up to next year’s midterm elections. 

For all of our sakes, we must wish Powell the best of luck in his second term. With the very weak hand that he has dealt himself, he will certainly need it.

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.