Could this be the ultimate poisoned chalice in monetary history? Joe Biden’s decision this week to grant a second term to Jay Powell at the Federal Reserve looked judicious from the administration’s perspective but the challenges that the chair faces rate close to 10 on the Richter scale.
It is not simply that inflation is racing away, with consumer prices up 6.2 per cent in the year to October while personal consumption expenditures, the Fed’s preferred measure of inflation, have risen 4.1 per cent over the same period, the highest level in three decades.
Powell has to secure the post-pandemic normalisation of monetary policy when President Joe Biden’s stimulus packages are driving demand at a frenetic rate relative to supply and the economy is plagued by bottlenecks.
This, according to former Treasury secretary Larry Summers, is “a consequential macroeconomic policy error”. It smacks of earlier fiscal excesses around the Vietnam war and Reaganomics, both of which ended badly. Today the absolute deficit numbers are much bigger, as is the level of debt.
The Congressional Budget Office projects that federal debt held by the public will rise from 103 per cent of gross domestic product at the end of 2021 to 106 per cent in 2031. This compares with less than 40 per cent at the time of the financial crisis.
It will thus be difficult for the Fed to raise rates in response to inflationary pressure without causing markets to collapse and precipitating recession. Monetary tightening could beget a perpetual cycle of financial instability, followed by more quantitative easing to prop up markets and support the economy.
Two questions arise. Is normalisation a chimera? And can the dollar’s role as the world’s pre-eminent reserve currency survive against a background of monetary instability and fiscal excess while the US continues to represent a declining share of global GDP?
The proximate cause of the inflationary surge relates to supply. This highlights a strange asymmetry in central bankers’ relations with the supply side.
On the one hand, Bank of England governor Andrew Bailey is right in saying that monetary policy cannot deliver more gas, more computer chips, more lorry drivers. On the other, ultra-loose monetary policy does have the power to create bubbles that cause mispricing of risk and misallocation of capital. This depresses productivity growth, which makes the task of debt reduction much harder.
When US debt was last at 106 per cent of GDP back in 1946, it was brought down by a combination of growth and inflation. Today, it is clear that the underlying trend growth rate of the US economy is running at anaemic levels, well below those of the immediate postwar period. This raises the possibility that inflation will have to do more of the debt reduction work this time, which is a strange kind of normalisation.
The way the requisite inflation will come about will be through what economists call second-round effects, most notably in tightening labour markets. This is already visible and will be exacerbated by demography as workforces around the world start to shrink and thus regain bargaining power.
US Treasuries are unrattled by the prospect that inflation may not be transitory and yield a negative real income after inflation. So a debt crisis is clearly some way ahead. So, too, with any potential decline in the dollar’s reserve currency role.
With excess global savings there is an insatiable demand for so-called safe assets in the shape of the enormous outstanding liabilities currently being created by the US. So 60 per cent of central bank foreign exchange reserves are still in dollar assets, with the eurozone following up with just 20 per cent.
As a new paper by Ethan Ilzetzki, Carmen Reinhart and Kenneth Rogoff points out, changes in the dominant global currency are rare. When they do occur, there is typically a long transition. Since the 1500s only Spain, the Netherlands, Great Britain and the US have seen their currencies reaching dominant status.
The authors nonetheless note that, while demand for dollar-denominated safe assets has exploded, the tax base backing those assets has diminished. The demand for safe assets, they say, risks eventually overwhelming the US government’s fiscal capacity to back them, adding that there is no guarantee that insatiable demand for such assets will continue.
In this debate the enduring question is, what are the alternatives to the dollar? With China set to overtake the US economy the renminbi, which commands just 2 per cent of global reserves, is clearly a contender. Yet many question whether a totalitarian state with weak institutions, fragile property rights and an interventionist way with markets can do the job.
In practice, the bigger challenge here for Powell will come if China succeeds in making the transition to a more consumer-driven economy, which would cause global savings rates to fall and real interest rates to rise. That is one more reason for markets to wake up and recognise that US government IOUs are very unsafe assets.