President Trump tweeted on Christmas Eve that he was “all alone (poor me).” It was a sentiment with which Fed Chairman Jerome Powell could sympathize.
As 2018 came to a close, the president blasted Powell for raising interest rates and causing the stock market to plunge. Wall Street pundits warned that swooning share prices suggest that Fed tightening has been excessive, and fading economic momentum is near at hand. Over on the left, which usually opposes whatever Trump is for, there was actually some agreement. Why, went the argument, should we be tightening credit when there is little inflation in consumer prices but a tightening labor market may finally be giving workers some bargaining power?
The reality of plunging share prices invoked a wholesale revision in thinking about Fed policy moves in 2019. As shares swooned futures markets stripped away expectations of several more tightening moves. By close of business 2018 the markets gave 30% probability to an easing of interest rates by March of 2019. As it happened, all of this occurred with little evidence of any here-and-now economic weakness. On Friday, insistence that we would soon see U.S. real economy retrenchment suffered a setback. Job growth ended 2018 on a very strong note, rising by 312,000. For the quarter, job increases averaged 254,000, the strongest quarterly gain in more than two years. Unemployment ticked up to 3.9%, but that was in large part due to people who had not been in the labor force deciding to look for jobs, and thus being counted as unemployed. Fourth quarter 2018 wage gains, year-on-year, were 3.2% before inflation, up from a 2.5% gain in 2017.
The strong U.S. jobs picture gave legitimacy to widespread evidence that fourth quarter U.S. consumer spending gains were robust. Bean counters estimate an annualized rise of 3.75%, stoking a gain for real GDP of around 3%. In sum, despite financial market pyrotechnics, real economy momentum remained robust, as 2018 came to a close.
Impressively, following on the heels of the robust December jobs report, share prices rebounded sharply. Think of the snapshot speculators confronted on Friday: Robust real growth was intact. And Fed tightening? Futures markets remained priced for zero increases in 2019.
It is tempting to embrace this snapshot. The swoon for shares, one could conjecture, put the Fed on notice that it dare not mess with economic momentum. With Fed tightening seemingly off the table, the markets, for a moment, feasted on the future imagined in early 2018, a future of strong economic growth, low inflation and steady interest rates.
Fed policy makers, as late as mid-December 2018, envisioned a decidedly different future. The median expectation for real GDP growth, 2.3%, would represent a sharp slowing from the likely 3.2% gain registered in 2018. Over the four quarters of 2018 employee hours rose by 2%. Unless the FOMC is betting on a collapse for labor productivity, their output forecast implies a sharp slowing for employment growth.
For the Fed to embrace a strategy of enthusiasm for heady growth, on the basis of low inflation, it would need to forget the principal lesson of the 2008 financial crisis. Hyman Minsky, an American economist who died in 1996, was right: Financial market excesses can be deeply destabilizing. Policymaker willingness to rescue financial markets from corrections fosters excesses with deadly consequences somewhere down the road.
Fed Chair Alan Greenspan treated inflation as the only excess of consequence, ignored asset market leaps, but cushioned asset market corrections. Spotting bubbles was obviously difficult, and solving the problems they created was not that hard, or so he averred. The Fed eases aggressively, and unfolding problems are ameliorated with little pain for the overall economy.
Greenspan’s strategy seemed to work after the bursting of the internet bubble in 2001. The much more severe recession that followed the bursting of the housing bubble was another story. Short-term interest rates were already low and cutting them to zero was not enough. Despite a plunge to zero for short term interest rates, direct infusion of government capital into the banking system, and large fiscal stimulus, recovery following the deep swoon was paltry. The Fed was forced into the uncharted waters of “quantitative easing” and the ballooning of its balance sheet.
On Main Street the anguish was extraordinary. Millions of people lost their jobs, and many lost their homes. The financial innovations that had been so widely praised ended up shifting the risks for bad mortgage loans in the United States to banks and investors all over the world.
Amid this brutal demonstration of flawed conventional thinking, Minsky suddenly became famous. The term “Minsky moment” entered the popular conversation. Minsky highlighted an easily overlooked point. Finance gets progressively riskier over the course of a business cycle.
Mainstream economists underwent some soul-searching. There was much talk that finance had to be included in models, but not much was done. In fact, mentions of Minsky declined roughly in line with fear in financial markets. As credit spreads slowly receded, so too did talk of the need to more broadly think about excesses, when contemplating policies.
At the moment, many economists are talking about the business cycle as if we have returned to the world of the 1960s. The Fed should tighten policy if, and only if, it can identify an inflation problem.
Powell, in his speech to the Jackson Hole symposium last summer, observed that 20th century thinking about excesses had not worked recently. “Whatever the cause,” he said, “in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses.”
This past November, the Fed, in its financial stability report, pointed to evidence of some emerging imbalances. “An escalation in trade tensions, geopolitical uncertainty, or other adverse shocks could lead to a decline in investor appetite for risks in general,” the Fed said.
“The resulting drop in asset prices might be particularly large, given that valuations appear elevated relative to historical levels,” the report added. “In addition to generating losses for asset holders, a significant fall in asset prices would make it more costly for nonfinancial businesses to obtain funding, putting pressure on a sector where leverage is already high.”
To be sure, indicators of financial system health certainly don’t look as menacing as they were in 2007. Banks appear to be much better capitalized. That said, risk appetites, leading into the recent correction, had been rising for nearly a decade and lending standards were easing. Letting excesses reach extremes, because you want no part of the retrenchment that may take hold amid tighter policy, is the soft option approach. The Fed tried it in the early 2000’s, to disastrous results.
Like today, the Fed chair in the 1950s and 1960s was not an economist. William McChesney Martin had an expansive definition of his job, “taking away the punch bowl just when the party is getting good.” Indeed.
Floyd Norris, a former chief financial correspondent of The New York Times, is a fellow at the Center for Financial Economics at Johns Hopkins University. Robert J. Barbera is director of the center.