Jay Powell ignores the stock market at the economy's peril

In 2017, a key mistake of the Federal Reserve was to keep monetary policy too loose despite the strong increase in U.S. stock prices that took place that year.

One now has to hope that current Fed Chairman Jay Powell does not repeat that mistake in reverse by keeping monetary policy unnecessarily tight despite the large fall in U.S. equity prices that has taken place since the summer.

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The truth of the matter is that, if sustained, large stock market price movements do have a material impact on economic growth. They do so through a so called wealth effect by influencing the way in which households feel about spending money.

In the good times when stock prices are high, households feel better about the state of their finances, and they are more ready to go out shopping. The reverse happens when stock prices decline.

In addition to the household wealth effect, the level of stock prices influence the ease with which companies can borrow money to invest. When stock prices are high, companies find it much easier to borrow and invest than they do when stock prices are low.

All of this has holds significant relevance for monetary policy, considering how large recent stock price movements have been. In 2017, during the first year of the Trump presidency, stock prices increased by some 25 percent. That move up increased household wealth by around 30 percent of GDP.

By contrast, since peaking in the first quarter of 2018, stock prices have fallen by some 15 percent. In the process, they have wiped out roughly 20 percent of GDP in household wealth.

According to Moody's, in time, households tend to spend 4.5 cents of every dollar by which their wealth increases on a permanent basis. This implies that the strong 2017 stock market boom might have eventually added around 1.25 percent to GDP growth.

By contrast, the strong decline in stock prices that we are currently experiencing over time could subtract around 0.75 percent from future GDP growth.

History will not judge Janet YellenJanet Louise YellenOvernight Energy: House Dem to offer measure backing Paris climate deal | Former Federal Reserve chiefs call for carbon tax | Watchdog urges agencies to update climate guidance Former Federal Reserve chairs, economists, back carbon tax Jay Powell ignores the stock market at the economy's peril MORE, the former Fed chairwoman, kindly for having allowed a stock market bubble to form and for having risked allowing the U.S. economy to overheat. She did so by not moving to a more aggressive interest rate-hiking path as the stock market kept rapidly rising.

The Fed’s 2017 behavior was all the more inexcusable considering that in addition to being boosted by a buoyant stock market, the U.S. economy was receiving a strong stimulus from a large unfunded tax cut, a weak dollar and a favorable international economic environment.

Today, Jay Powell’s Fed would seem to be facing a diametrically opposite situation to that faced by the Yellen Fed in 2017.

Not only are stock prices down off their recent highs, the U.S. economy is also being buffeted by the combination of a strong dollar, a synchronized weakening in the international economy and the fading effects of the Trump tax cut.

Against this backdrop, one has to be encouraged by Jay Powell’s change of tone on the need for further interest rate increases this year at the recent American Economic Association annual gathering.

One also has to hope that at the Fed’s scheduled meeting at the end of this month, he goes further by suggesting that the Fed is now considering the case for an easing in monetary policy.

He could do so by intimating not only a possible cut in the Fed’s policy rate sometime during 2019 but also by floating the possibility of a reduction in the current pace at which the Fed is reducing the size of its balance sheet.

Needless to add, by publicly attacking the Fed for keeping interest rates too high, President TrumpDonald John TrumpTrump directed Cohen to lie to Congress about plans to build Trump Tower in Moscow during 2016 campaign: report DC train system losing 0k per day during government shutdown Senate Republicans eye rules change to speed Trump nominees MORE is highly complicating its task. By so doing he makes it difficult for the Fed to move to easier monetary policy for fear of losing credibility in its independence.

The greatest contribution that President Trump could make to monetary policy implementation is to underline his full confidence in Jerome Powell and to leave it to the Fed to do the right thing.

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.