Caught in the middle of the Brexit saga, European investors can be forgiven if they glossed over a speech by Fed Chairman Jerome Powell that could turn out to be the starting point of a very risky period for the global economy.
It’s no secret that President Donald Trump would want the Fed to cut interest rates and debase the dollar. Earlier this year, he called the Fed “crazy” and Powell himself, “clueless.”
Of course, Powell did not immediately show that these repeated attacks influenced his policy. However, in a speech he gave last week he reiterated his fondness for a very risky idea on how to ease monetary policy even further.
According to a report in the Financial Times, in a speech in Zurich Powell again developed at some length the idea of make-up inflation – the central bank “making up” for the sins of the past in what regards price rises.
In other words, when a central bank undershoots its inflation target, it should then make up for it in subsequent periods by allowing it to overshoot the target.
It is not the first time Powell has spoken publicly about this idea. In a speech in June, he explained that the simplest version of the make-up strategy would be that a central bank could “promise credibly” that it would make up for lost inflation by “stimulating the economy and temporarily pushing inflation modestly above the target.”
“In the models, the prospect of future stimulus promotes anticipatory consumption and investment that could greatly reduce the pain of being at the effective lower bound rate,” he said.
The “effective lower bound” rate is reached when central banks have cut interest rates so low, that pushing them even lower would achieve nothing in terms of stimulating the economy.
With one third of global debt now paying negative nominal yields and the world economy on the brink of recession, it is safe to say the effective lower bound has been reached almost everywhere.
Despite central banks everywhere pushing the pedal to the metal, sentiment is turning from bearish to extremely bearish, as illustrated by Bank of America Merrill Lynch’s Bull & Bear indicator:
In this context, Powell’s idea doesn’t seem all that crazy. After all, central banks need to do something, and this is something.
However, for such an idea to work, the world in which it is applied would need to be completely different. The fact that it works in models is not a guarantee that it would work in real life – in fact, it may be just the opposite.
If a central bank cuts interest rates in the face of rising inflation, it has a very short time window before it needs to catch up, or prices will go through the roof. This has been demonstrated time and again in various hyperinflationary economies throughout history, and has been happening primarily because people have lost confidence in the currency.
What Powell is saying now is that central banks could somehow explain their thinking clearly enough to ordinary people on the street to determine them to watch the currency depreciating and prices of essential goods rising and take no action to stockpile staples, save more that usual, or reduce non-essential consumption — which is what people do when they are uncertain about the future.
“For make-up strategies to work, households and businesses must go out on a limb, so to speak, raising spending in the midst of a downturn. In theory, they would do this based on their confidence that the central bank will deliver the makeup stimulus at some point — perhaps years in the future,” the Fed chairman said in his speech earlier this year.
Powell is essentially suggesting that people should have faith in central bankers. It’s not just Goldman Sachs that believes banks are doing God’s work, then.