2023-03-16 09:56:45 ET
Summary
- Jerome Powell, the Fed chairman, and the Federal Reserve must continue on the path to fight inflation: they must keep their eyes on their inflation target!
- Mr. Powell and the Federal Reserve have lost credibility over the past several years, as they have continually seemed to err on the side of monetary easing.
- This error has resulted in an asset bubble and subsequent behavior that has brought the U.S. economy and the banking system to its current state of disorder.
- And, even though Mr. Powell and the Fed must keep their eyes on the health of the commercial banking system, they must continue their battle with inflation to buy back credibility.
- This is not going to be an easy job, but, if the United States financial system and the United States economy are to regain their strength and stability, this goal must be achieved.
Yesterday, I wrote a post outlining the dilemma that Fed chairman Jerome Powell and the Federal Reserve face as they go forward with dealing with the Fed's battle against inflation and the financial concern that exists caused by recent bank failures.
What should Mr. Powell and the Fed do?
The whole situation, to me, now boils down to a test of the credibility of Mr. Powell.
As I tried to define in my post, Mr. Powell suffered a loss of credibility in his early days as the chairman of the Board of Governors of the Federal Reserve System. Investors came to see Mr. Powell in the Fed's policy decisions always trying to err on the side of monetary ease.
That is, Mr. Powell moved to protect the U.S. economy and banking system from a collapse associated with the spread of the Covid-19 pandemic and the consequences of this spread.
But, Mr. Powell always made decisions that resulted in the Fed putting excessive amounts of liquidity into the banking system in order to minimize the possibility that a greater collapse of the financial system might occur.
The consequence of this "looseness" was an asset bubble, a situation that the Federal Reserve is now trying to reverse.
But, Mr. Powell has faced concern about his credibility as a result of the stance he took during the period in which the Fed was buying $120.0 billion worth of securities every month. This effort of quantitative easing injected trillions of dollars into the banking system.
It also helped to keep interest rates very, very low.
Fighting To Regain Credibility
In the period following the end of quantitative easing, Mr. Powell has had real problems attempting to regain credibility as a responsible chairman of the central bank of the United States.
One piece of evidence of this questioning of his credibility is the problem the Fed has had in convincing investors that the Fed was very serious about its efforts to battle inflation.
In the middle of March 2022, Mr. Powell and the Fed moved to start raising its policy rate of interest and moved to initiate a round of quantitative tightening that would reduce the size of its securities portfolio.
Soon after this policy program was introduced, the U.S. stock market started to decline.
However, in the summer and fall of 2022, there were several periods when the stock market rebounded.
The reason for the rebound was a feeling on the part of investors that Mr. Powell and the Federal Reserve would not sustain their restrictive monetary policy and "bank off" raising the policy rate of interest.
The concern...the Federal Reserve would not continue its fight against inflation and so stock prices were bound to rise.
This market action continued over into 2023.
Investors were constantly expecting Mr. Powell and the Fed to "pivot" in the fight against inflation.
Where We Are Now
We are coming up to the next meeting of the Federal Open Market Committee. It is scheduled for next Wednesday.
The question: What will Mr. Powell and the Fed do with its policy rate of interest?
Since the FOMC meeting on March 16, 2022, the Federal Reserve has raised it policy rate of interest at every meeting.
Now, what will it do?
The dilemma!
And, the decision, to many, is one that will help to define the Fed's credibility.
Nick Timiraos quotes in the Wall Street Journal these words spoken by Michael Feroli, the chief U.S. economist at JPMorgan Chase:
"A pause now would send the wrong signal about the seriousness of the Fed's inflation resolve."
Mr. Timiraos goes on to interpret what Mr. Feroli said:
"It could also fuel fears that the Fed is hesitant to raise rates but quick to cut them, because of concerns about financial stability."
The issue is all about the credibility of Mr. Powell and the Federal Reserve.
Mr. Timiraos then provides the following information: on Wednesday, futures markets saw a nearly 70 percent chance that by year's end, the Fed would cut rates to below 4.0 percent.
One week ago, comments were made by Mr. Powell indicating that the Fed, most likely, would move its policy rate of interest up further this year. The futures market, at that time, saw almost no chance that the Fed's policy rate of interest would be below 4.0 percent.
What Mr. Powell Must Do?
Mr. Powell and the Federal Reserve, I feel, must continue to fight their battle against inflation.
Mr. Powell and the Federal Reserve must continue to try and regain all the credibility they can.
One could assess some of the blame for the failure of Silicon Valley Bank on Mr. Powell and the Federal Reserve.
When Mr. Powell and the Fed began to move the Fed's policy rate of interest up and began its efforts of quantitative tightening, banks should have taken the Fed's efforts to mean that interest rates, in general, were going to rise and that, consequently, bond prices were going to fall.
But, as we have argued above, many investors in the financial markets kept looking for the Fed to "back off" its tightening and "pivot" toward an easier monetary stance.
It the central bank had "backed off" and "pivoted," then holding onto longer-maturity bonds would not have been such a risky position.
However, SVB Financial Group (SIVB) and other investment organizations did not alter their positions.
And, failure followed.
Now, inflation is still a major problem that the Federal Reserve must deal with.
A 6.0 percent year-over-year rate of inflation is not acceptable.
The Fed still must deal with this.
The problem of bank failures?
The Fed must maintain its fight against inflation, keeping an eye on the health and stability of the banking system.
The fight against inflation must come first.
Mr. Powell and the Federal Reserve must regain their credibility so that the community it oversees acts in a way that is consistent with the current stance of monetary policy.
All of the government's oversight organizations are now on watch. Moves have been made to help protect the banking industry. Given this added protection must also allow the Fed to continue the inflation fight.
So, Mr. Powell and the Federal Reserve must continue doing what they have been doing.
For further details see:
Fed Needs To 'Stay The Course'