By John Mauldin
Two months ago, Fed Chair Jerome Powell set off a market panic.
He suggested the FOMC would do what it thinks is right and let asset prices go where they may.
They promised at least two if not three more rate hikes in 2019. The stock market fell out of bed.
Fast forward to now. The Fed has given up its tightening dreams and might even loosen policy. It is even (gasp!) losing its fear of inflation.
The problem is that preventing small “crises” on a regular basis eventually causes a very large crisis.
It’s like not allowing small forest fires to clear out undergrowth. Eventually you get one very large fire which is far more destructive.
Playing with Fire
The Fed and its peers in other counties are supposed to worry about inflation. It’s one of their official mandates.
Not that they are against inflation completely. They just want it to happen on their terms.
For the Fed, acceptable inflation is 2% (as measured by PCE). It ran below that level for most of this growth cycle and is only now catching up.
So they should be happy. They are not, for some reason…
A few weeks ago, Richard Clarida, the new Federal Reserve vice chair, told a monetary policy conference at the University of Chicago that the Fed might give itself a little do-over.
They would allow a period of above-2% inflation to compensate for the years it was below the target.
We’ve heard this before.
Fed officials sometimes talk about letting the economy “run hot” since it was lukewarm for so long. They haven’t done so because the economy hasn’t wanted to run hot.
What would be “hot” in this context is unclear. Maybe 4% real GDP growth? If that’s what they now consider unusually strong, we have bigger problems.
2018 appears to have been the best year since 2005 at roughly 3% growth.
In any case, this is a dangerous game. The Fed has little control over how such inflation would be distributed.
If it shows up mostly in asset prices, it will reward the wealthy and punish the lower 80%. The latter will face higher costs for housing, health care, and other essentials.
That is a political problem.
S&P 500 Dependent
Last week on Capitol Hill, Jerome Powell noted the Fed is watching the markets:
“Financial markets became more volatile toward year end, and financial conditions are now less supportive of growth than they were earlier last year.”
Powell went on to say the Fed remains “data dependent” and that it could adjust the balance sheet based on “financial and economic developments.”
My friend Peter Boockvar noted that Powell really meant “S&P 500 dependent.”
Jay Powell is implicitly saying to Congress that the Q4 direction of the stock market is the number-one reason why they have become more flexible with rates and its balance sheet. Weakness in China and Europe is number two. Thus, keeping asset prices elevated is officially the #3 mandate of the Federal Reserve.
It looks like Powell has backed down and is now bent on pleasing investors. It’s the exact opposite of the impression he gave in December.
This Will Harm Everyone
Why the change? Did the economic data change significantly? I don’t think so.
My best guess is Powell simply got cold feet. He is worried about recession on his watch and wants to prevent it. Or at least make the Fed look less responsible for it.
Can this U-turn have short-term, market-friendly results? Absolutely. For longer than we might think? Assuredly.
But while Powell might buy another year or so, he is probably changing the course too late.
Look, there is no free lunch. Large deficits will have a cost. Yes, more QE of $3 trillion or $6 trillion or more is possible. But it will come at a cost.
And the cost will be slower economic growth and greater wealth and income disparity. It may not be a crisis, but more of a slow grind that requires a different investing mindset.
Right now, investors seem happy to have the Fed back on their side. I think we may regret having that wish granted.