Jerome Powell, the new head of the U.S. Federal Reserve, at his confirmation hearing in Washington on Nov. 28, 2017.TOM BRENNER/The New York Times
When Jerome Powell is sworn in Monday as the new chairman of the U.S. Federal Reserve, the pride of the moment may be tempered by Mr. Powell's recognition of the risks that lie ahead.
A ferocious sell-off on Wall Street on Friday – with stocks tumbling and bond yields rising after the January U.S. jobs report suggested higher inflation lies ahead – served as a blunt reminder of the challenges the Fed now faces.
At his Senate confirmation hearing, Mr. Powell stressed his intention to carry on the cautious approach to interest rate hikes that his predecessor, Janet Yellen, pursued in four years as Fed chair. Ms. Yellen was able to oversee a gradual rate policy because inflation posed no threat: It ran below even the Fed's 2-per-cent annual target throughout her tenure.
The Powell era could be entirely different. The job market is tighter. Wages are up. U.S. federal debt will likely rise. Tax cuts could accelerate growth.
All of which seems likely to drive up inflation, which is what spooked investors Friday. The main question is by how much? For weeks, investors have been demanding higher bond yields. On Friday, after the government said average pay rose year-over-year in January at the fastest pace in more than eight years, the 10-year U.S. Treasury yield reached 2.84 per cent, a four-year high.
The Powell-led Fed would be pleased to see inflation finally reach its 2 per cent goal. The problem would be if it were to surge well above that level. The Fed would face intense pressure to accelerate its rate hikes to tighten credit and curb inflation.
That's where the risks come in: If the Fed tightens credit too little, inflation might surge out of control. If it tightens too much, a recession could result. Steering a safe middle ground has proved tricky for the Fed throughout its history. It has sometimes miscalculated how fast to raise rates and triggered an economic downturn.
In December, the Fed predicted that it would raise its benchmark short-term rate three times in 2018, just as in 2017. Yet some economists now foresee four increases. And those rate hikes would coincide with the Fed's continued paring of its bond holdings – action that puts upward pressure on rates for long-term consumer and business loans.
"The next phase of managing the economy may not be as easy," said Diane Swonk, chief economist at Grant Thornton, who expects four rate increases in 2018. "The Fed may have to raise rates more quickly because the economy is stronger."
For now, the economy that Powell's Fed will preside over shows strength and resilience. Unemployment is at a 17-year low. The economic expansion, already the third-longest in U.S. history, appears to be improving after a long stretch of subpar growth. On the surface, it might seem that all the Powell Fed needs to do now is serve as caretaker for a high-flying economy. But the Fed has always felt compelled to respond to threats before, not after, they arisen.
"Everything points to a more aggressive Fed under Powell," said Mark Zandi, chief economist at Moody's Analytics.
No less an authority than Alan Greenspan, who led the Fed for 18.5 years until 2006, expressed worries last week that dangerous bubbles might be forming in the financial markets, in part because of high federal debt resulting from increased benefit spending as baby boomers retire and the US$1.5-trillion in tax cuts now taking effect.
"We are dealing with a fiscally unstable long-term outlook in which inflation will take hold," Mr. Greenspan said in an interview on Bloomberg Television.
The two most recent U.S. recessions were caused by bursting asset bubbles. The pricking of the dot.com bubble led to a brief recession in 2001. And the collapse of the housing bubble ignited the 2007-2009 downturn, the worst since the Great Depression of the 1930s.
The current recovery began in June, 2009. If it lasts until June, 2019, it would tie the longest expansion on record – the one that lasted from March, 1991 to March, 2001.
Though the expansion has been marked by slow economic growth, that very trait might ensure its durability: Plodding growth has kept inflation low and prevented the economy from overheating.
"I don't think a recession is on the horizon," said Sung Won Sohn, an economics professor at California State University, Channel Islands. "We have had one of the slowest periods of economic growth on record, and I think slow means it will go for a longer period."
For that forecast to prove correct, the Powell Fed will need to manage its rate policy with exceeding care. Friday's jobs report showing wages rising 2.9 per cent over the past 12 months – the biggest such jump since the recession ended in 2009 – suggested that the Fed may be entering an era of higher inflation and a need for higher rates.