Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Charlie Diebel, head of rates for Aviva Investors assesses the new Fed chair.
Jerome Powell took the helm from Janet Yellen at the Federal Reserve on February 3, after winning confirmation in the US Senate by a wide margin. He is seen as a safe choice by President Trump and a consensus builder, who is expected to maintain a steady hand on the tiller of the US central bank.
The macro-economic conditions Powell and the Fed board encounter may change in the near term, however. It may be quite different than the largely benign environment Yellen faced, requiring a different approach to monetary policy.
Inflation is perhaps the biggest issue facing Powell and the Fed. Many economists have been surprised by its relatively muted nature. As the job market tightens, wage pressures ought to build and inflation should follow. There are signs this is finally happening in the US corporate sector. Walmart recently decided to raise its minimum wage and other firms are paying one-time bonuses to employees.
Although Powell assumes Fed leadership after a period of calm, the central bank is in a tough position. Its dual mandate of promoting employment and managing inflation won’t change. At some point, inflation pressures are expected to show through, prompting the Fed to get more aggressive with rates.
The danger is that it lets the US economy run hot. And judging by the three rate hikes in 2018 indicated by the Fed dot-plot chart, it probably thinks it already is – to an extent. Indeed, reading the nuances of recent Fed comments, four hikes is possible. The Fed appears to be building some wiggle room in case cooling-off is required.
What Next for the Fed?
Learning lessons from previous rate-hiking cycles, it seems unlikely the Fed would allow the US economy to overheat. Powell’s expected centrist vision is unlikely to change this, either. If and when inflation spikes up, it is hard to see the Fed Board of Governors reacting quickly.
If there is an asymmetrical bias to rate risk, it is that the Fed does more rather than less. Previous monetary “doves” like New York Fed chair William Dudley have morphed into rate “hawks”. For the most part, the Fed board believes the medicine of policy accommodation has largely worked. The economy is growing, inflation is accelerating and they can put rates on a more ‘normal’ path.
Could the Fed Change Tack Under Powell?
It is possible that under Powell the Fed does not stick to the recent pace of rate increases. In the rate-hiking cycles of 1994 and 1995 and 2004 and 2005, the Fed bumped rates at every meeting. That is not part of the discussion currently.
But why couldn’t the Fed do a half-point hike rather than the expected quarter-point increase, if inflation accelerates more quickly than the market expects and it fits in with the Fed’s meeting cycle? Interest rate hikes could remain as infrequent as they have been, just perhaps more sizeable.
Other potential Board of Governor appointees also indicate the Fed will continue to adhere to its mandates and aim for calm. President Trump has the opportunity to add three members to the Fed’s board, including vice chair. Trump is capitalising on a strong economy and stock market performance to promote his agenda and boost his re-election prospects. He is unlikely to disrupt this by nominating a Fed governor who is too evangelical about rates one way or another.
If the Fed gets too hawkish for Trump’s liking, he could pressure Republicans in the US Congress to rewrite the Fed’s mandate. This is a risky strategy. Better to let the Fed do its job and not get in the way.
The central bank has a well-established doctrine and is served by entrenched experts and economists whose views are largely fixed. Radical change would have to be forced upon them. However, the economy is Trump’s good news story and there is no incentive for him to do anything that would change it.
Only a bigger than expected leap in inflation could force the Fed to adopt a more active approach to rate hikes than Trump or the market would like. Market nervousness over an inflation spike has largely driven the move in bond yields over the last few months. It now comes down to whether the Fed has its “game face” on if and when inflation finally accelerates.
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