Weekly Asset Allocation: Powell and Fed Independence
Confluence Investment Management offers various asset allocation products which are managed using top down or macro analysis. We publish thoughts on asset allocation on a weekly basis in this report, updating the report every Friday, with an accompanying podcast.
President Powell’s term as head of the FOMC ends in early February 2022. It seems likely, at that point, that he will be reappointed for another four-year term. Decision-making markets currently rate the odds of another term at 85%. Given all the political actions that are on the agenda for this fall – an infrastructure, budget and debt ceiling bill – let alone the political capital lost to Afghanistan, it seems unlikely that the administration has enough bandwidth to push a new Fed president through Congress. The path of least resistance is to rename Powell.
However, less resistance does not mean no resistance. Left-wing populists in Congress want another Fed chairman. This group thinks Powell is too lenient on banking regulation and wants someone more committed to climate change policy. Powell mainly pursued an accommodating monetary policy.
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This chart shows the actual federal funds rate; Powell’s term is represented by the vertical line. Although he briefly had a positive real policy rate in parts of 2018 and 2019, most of his tenure was marked by negative real policy rates. And his swift response to the pandemic has been widely praised.
Opponents of Powell’s reappointment are really grappling with the philosophical issues surrounding the central bank. The question really is whether central banks should be independent or not. There is a long-standing divergence in stance on central bank independence. For those who oppose it, the argument is that the central bank should have monetary policy aligned with fiscal policy. This is often referred to as the âwhole-of-governmentâ approach. It makes sense that policy evolves in one direction; it does not make sense for government policy to work against the grain and this result is possible with an independent central bank. During World War II, the Fed stabilized interest rates in order to support the war effort. This is a classic set of government policy. This would have caused problems if the Fed had raised rates to offset the effects of government spending on the war effort.
It seems to us that Powell’s opponents are really pushing for a whole-of-government approach. The argument seems to be that the issues of inequality and climate change are so critical that normal political approaches are not justifiable. Instead, the Fed should conduct monetary policy to support the government’s efforts to transform the fossil fuel economy and reduce inequality. Therefore, budgetary outlays aimed at reducing the impact of climate change should be taken into account by expanding the balance sheet to provide affordable financing.
Those who advocate the independence of the central bank stress that money is essential for the proper functioning of society. There are basically two ways that corporations have tried to impose monetary stability. The first is to link monetary creation to a commodity, often gold. The idea is that users will have more confidence in the currency-based store of value if supply control is given to an entity outside of government. Since gold is created through mining, the money supply is independent of government actions.
The second way in which corporations have created a stable currency is the independence of the central bank. The idea is that if the central bank’s main job is to defend the value of money (which is ultimately to stabilize inflation), and if it can act independently of fiscal policy, then a stable currency can be created. For the most part, most countries have stopped using a metallic standard for silver; in practice, standard metal money was too rigid. During periods of industrialization, when the supply of goods has increased, the supply of gold may not increase quickly enough to prevent deflation. History shows that consumers and businesses tend to act asymmetrically in the face of deflation relative to inflation. Deflation tends to depress consumption and investment because there is less incentive to spend as prices fall; the longer you wait to buy, the better the price. Thus, governments have concluded that moderate inflation is the best outcome for society. Since the 1980s, there has been a consensus that central bank independence coupled with a clear inflation target was the best way to stabilize the currency.
Policy differences have tended to be limited within the framework of central bank independence. There have been debates between âhawksâ and âdovesâ about how the policy should be implemented. In general, hawks lean towards keeping an inflation target low and a preemptive movement to ensure that the target is not violated, while doves tend to be more forgiving when violating the target. inflation target to support economic growth. Recent actions, led by President Powell, to loosen the inflation target suggest he is leaning dovishly on policy.
In general, the argument for the whole-of-government approach is that it makes little sense for government policy to work against the grain. If the economy needs stimulus, why should fiscal policy be relaxed while monetary policy is tight? The downside to this approach, as history indicates, is that every government believes its goals are sacrosanct and wants no compulsion; this situation will tend to lead to higher inflation. The monetary stability approach, on the other hand, suggests that money is too important to be left solely in the hands of the political class. Left to their own devices, politicians will tend to put less emphasis on monetary stability. Thus, either a metallic standard or the independence of the central bank is necessary. Critics of this approach argue that the policy can be too restrictive.
What the left-wing populists are proposing is not simply a conciliatory policy, but a radical change in the conduct of monetary policy. Selecting another Fed chairman is unlikely to accomplish this result; the Federal Reserve-Treasury Agreement of 1951 established the independence of the Fed. It would likely take a larger act of Congress to accomplish what left-wing populists want.
For investors, this debate is of crucial importance. While President Powell is likely to be re-elected, the push for a whole-of-government approach is something worth watching. Modern monetary theory assumes a non-independent central bank and this theory has gained traction. A move away from central bank independence increases the chances of higher inflation and fewer constraints on government policy. Although the Fed remains independent, this policy is not scriptural; it comes from Congress and can be withdrawn by that same body.
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