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As a fellow citizen, allow me to wish you, Federal Reserve Chairman Jerome Powell, the best of luck in your stewardship of the country’s economy.
I need not tell you that your task will be most challenging. This is especially the case since you will be inheriting an economy that is beset by two conflicting tendencies.
On the one hand, the U.S. economy is on the verge of overheating, which risks reviving past ghosts of inflation. Yet on the other hand, the U.S. and global economies would seem to be in the midst of an asset price bubble, which if it bursts could derail the U.S. economic recovery.
May I offer you three pieces of advice as to how you might better conduct monetary policy during your tenure than did Chairwoman Janet Yellen?
I do so in the hope that this might help you to avoid making the same mistakes that she made and that this might allow you to leave your successor with a very much less challenging task than she left you.
The first piece of advice is that you should pay very much more attention than did Chairwoman Yellen to financial conditions in your setting of monetary policy. By this I mean that rather simply focusing on how interest rates might affect the economy, you should also take into account how large increases in stock market prices and large dollar depreciations might boost the economy.
Sadly, this was evidently something that Yellen did not do, which goes a long way to explain why the economy is now at risk of overheating. Instead, during the past year, her Fed doggedly stuck to the interest rate increase path it set for itself at the start of the year, despite the roughly $6 trillion increase in the stock market and despite around a 10-percent dollar depreciation since President Trump took office.
This has left the U.S. in a highly inappropriate policy position at this late stage of the economic cycle. By most estimates, U.S. financial conditions are now at their easiest level in decades. This is the case despite the fact that the economy is at very close to full employment and despite the fact that it is now receiving a significant boost from the Trump tax cut.
The second piece of advice is to take to heart Nobel Laureate Milton Friedman’s warning that monetary policy works with long and variable lags. By this he meant that monetary policy should be forward looking and should not be engaged in fine tuning.
Sadly, Yellen’s Fed seems to have forgotten this lesson when it lost confidence in its forecasting abilities and instead became highly data-dependent in its monetary policy decisions.
Past experience should have informed her that the trouble with this approach is that if one waits for clear signs of accelerating inflation before reacting with interest rate increases, one might have let the inflation genie out of the bottle and thus have real trouble in getting inflation back under control.
The last piece of advice is to pay very much more attention than did former Fed Chairman Ben Bernanke and Yellen to asset price inflation both at home and abroad. Failure to do so would risk keeping the U.S. and global economies trapped in the 10-year economic boom-bust cycles that they now seem to be experiencing.
In this respect, it would not seem to be too early to start thinking about how economic policy should respond to the eventuality of another sharp downturn in the U.S. and global economies should the global asset price bubble burst.
The mistake made by the Bernanke and Yellen Feds was to rely excessively on aggressive quantitative easing to get an economic recovery going. While this did produce an economic recovery, it did so at the long-run cost of seriously distorting financial market asset prices, thereby setting up the stage for the next economic bust.
In the event of an economic bust, rather than heed the siren calls for yet another round of quantitative easing, you should make every effort to educate Congress and the administration of the risks of once again placing too heavy a burden on monetary policy to revive the economy.
Instead, you should push strongly for some variant of Milton Friedman’s “helicopter money” that would involve the Fed financing on the easiest of terms the Treasury mailing a check to every citizen. You should do so in the hope of stimulating an economic recovery without at the same time once again seriously distorting financial market prices.
I realize that in today’s political climate it will be very challenging for the Federal Reserve to stay on a prudent monetary policy course. However, I also realize that not doing so could prove to be very damaging for both domestic and global economic prosperity.
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.
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