Despite success, Fed must be more vigilant than ever

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Kudos to Federal Reserve Chairman Jerome Powell and Vice Chairman Richard Clarida on their masterful speeches two weeks ago.

These speeches sent the choppy stock market indices higher by up to 3 percent despite any material change in the Fed’s stance on interest rates. But this is not the time for the Fed to rest on its laurels, as success can turn into failure with as little as a quarter-percent change in the federal funds rate.

{mosads}For the past two years, the Fed’s monetary policy has been constant: Set interest rates based on incoming data and the analyses of the Fed’s board members. This was clearly reflected in the speeches of Powell and Clarida.

Their tone assured that if they get any whiff of a staling economy, they will rethink their interest rate strategy. Such a whiff may have already been detected by the Fed. But what if unanticipated factors, such as war or stock market collapse, rear their ugly heads?

Clarida’s speech on Nov. 27 at The Clearing House and Bank Policy Institute Annual Conference in New York was aptly titled, “Data Dependence and U.S. Monetary Policy.” Clarida asserted that the “economic fundamentals are robust,” reflecting a low unemployment rate of 3.7 percent and a low inflation rate close to 2 percent.

To assure this performance, Clarida said he believed that “monetary policy at this stage of the economic expansion should be aimed at sustaining growth and maximum employment at levels consistent with our inflation objective” of 2 percent.

To stay the course, Clarida said that monetary policy must be data-dependent; that is, a monetary policy that combines “incoming data and a model of the economy with a healthy dose of judgement …”.

Powell’s speech came a day later at The Economic Club of New York. Using Clarida’s blueprint, Powell said he expects “solid growth, low unemployment and inflation near 2 percent.” He then asserted that “there is no preset policy path. We will be paying very close attention to what incoming economic and financial data are telling us.”

While the Fed’s job is to assure maximum employment and low interest rates, it must consider that it is operating within a rocky and unpredictable political and social system. Such consideration may affect its interest rates decisions.

To an extent, this may have already been reflected in the Clarida and Powell speeches. They suggested sensitivity to things beyond interest rates and employment and that the Fed should resolve to communicate its monetary strategy to assure stakeholders that the Fed is on the ball at all times.

Nevertheless, the Fed’s job is bound to get harder in the coming year. Interest and unemployment rates are already very low, so there is a greater risk posed from relying on the presently solid but laggard rates than from adding relevant, forward-looking variables to the mix.

And while the Fed’s steady-state monetary policy formulation can help it set successful policy, it is the unexpected, volatile shock factors that can derail success. By nature, such factors can not be easily identified, nor their effects clearly estimated. These could include:

  • war or a limited U.S. engagement that could increase inflation and spur the Fed to increase rates; 
  • a slowing global economy that will reduce demand for U.S. exports and could push the Fed to change rates;
  • escalating tariffs that could reduce consumer demand and increase unemployment, requiring rate reduction;
  • a sudden stock market collapse or extreme volatility that will make consumers feel poor or nervous and reduce their demand for products and services;. 
  • continued interference from the White House, which could push the Fed to take unwarranted action, affecting unemployment and inflation.

{mossecondads}Furthermore, even if these factors can be identified, it is important to note that they are not necessarily linear. For example, the effect of a 25-percent tariff is not just 2.5 as much as the effect of a 10-percent tariff. Rather, its magnitude could be subject to a multiplier effect and could set in suddenly, even after a period of no detectable impact.

As a result, Powell’s response must be vigilant, dynamic and variable, depending on the nature and extent of the affecting factor. The Fed’s task becomes even more challenging when facing several nonlinear factors pushing the Fed in different directions, i.e., stock market collapse or war.

Powell must beware of resting on the laurels of his success, as the economy may be harboring the kernels of rapid disruptions from known and not-fully-known factors. 

Avraham Shama is the former dean of the College of Business at the University of Texas, The Pan-American. He is a professor emeritus at the Anderson School of Management at the University of New Mexico, and his book about stagflation, “Marketing in a Slow-growth Economy,” was published by Praeger Publishing.

Tags economy Federal Reserve Federal Reserve System Financial economics Inflation Interest rate Macroeconomic policy Macroeconomics Monetary policy Money Richard Clarida Unemployment

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