Penn Mutual Asset Management CIO Mark Heppenstall contributed an article to The Hill where he discusses the market’s reaction to the appointment of new Federal Reserve (Fed) Chair, Jerome Powell. Mark anticipates as the primary fear factor in markets transitions from deflation to reflation, the Fed will be forced to abandon gradualism and hike rates faster than expected. The post originally appeared on The Hill on 3/19/18 and can be found below.
Financial markets have a history of providing challenges for newly minted Federal Reserve chairmen, but never so quickly as Jerome Powell had to confront them last month. Powell’s swearing in ceremony the morning of Feb. 5 was immediately followed by the largest stock market selloff since the Brexit vote in 2016.
The Dow Jones Industrial Average closed the first day of his term 1,200 points lower as markets abruptly closed the book on an extended period of record low volatility and steady upward momentum. That Monday’s market turbulence actually started the Friday before, with the release of the January employment report. Higher than expected wage growth, a missing piece of the post-crisis economic recovery, stoked inflation fears and drove 10-year Treasury yields to the highest levels since the 2013 “Taper Tantrum.”
Powell’s selection as chairman came only after months of speculation and a drawn out process with numerous candidates spending time as the frontrunner. President Trump ultimately selected the candidate most like Janet Yellen without naming her. After bashing the easy money policies under Ben Bernanke and Yellen during his run for office, Trump, the self-proclaimed “king of debt,” ended up looking beyond “hard money” candidates like Kevin Warsh and John Taylor.
Powell, who never dissented to a rate decision in his nearly six years at the Federal Reserve, will be counted on by the Trump administration to extend the current low interest rate environment as long as possible to help finance ballooning deficits resulting from Republican tax cuts and spending plans.
President Obama’s second term plans for fiscal stimulus were derailed after underestimating Republican willingness to live with military spending cuts. Passage of the Bipartisan Budget Act of 2018 demonstrates Republican demands for fiscal restraint are more pliable with a Republican in the White House.
Increased defense and nondefense spending in the new budget agreement on the heels of recent tax cuts represents fiscal stimulus at a time late in the economic cycle, when restraint is more the norm. Proposed infrastructure spending coupled with an increasing dose of trade protectionism promised by Trump also raises risks the Federal Reserve may fall further behind the curve.
In the Yellen playbook for monetary policy, gradualism was only made possible with inflation measures regularly coming in below the Federal Reserve’s 2 percent target. The board’s preferred inflation gauge, the core personal consumption expenditures, has consistently been below the 2 percent level for 20 years and fell further below target last year, despite continued tightening across labor markets. The real test for Powell will likely come from the source and not the symptom of recent market turbulence, namely higher inflation.
With deflation frequently topping the list of investor concerns since the financial crisis, global central banks would offset times of market stress with new and innovative forms of money printing, while normalization of monetary policy was pushed further down the road. This dynamic created the post-crisis mantra of “bad news is good news” and helped fuel gains in financial assets even as the real economy was stuck in neutral.
As the primary fear factor in markets transitions from deflation to reflation, the Federal Reserve will be forced to abandon gradualism and hike rates faster than expected. Investors should not be surprised by a new investment landscape characterized by “good news is bad news,” with a much bumpier ride for financial markets. While Powell was widely praised for his steady hand after being nominated by Trump, expect it to be put to the test as the “Goldilocks economy” starts to warm up too quickly.