Could this be the last poisoned chalice in monetary history? Joe Biden’s decision this week to give Jay Powell a second term at the Federal Reserve seemed sound from an administration’s point of view, but the challenges the president faces are near 10 on the Richter scale. .
It’s not just that inflation is accelerating, with consumer prices rising 6.2% in the year through October while personal consumption spending, the preferred measure of the Fed inflation rose 4.1% over the same period, the highest level in three decades. .
Powell must ensure post-pandemic monetary policy normalization when President Joe Biden’s stimulus packages drive demand at a frantic pace over supply and the economy is in bottlenecks.
This, according to former Treasury Secretary Larry Summers, is “a consequent macroeconomic policy error.” It smacks of past budget excesses around the Vietnam War and Reaganomics, which both ended badly. Today the absolute deficit figures are much larger, as is the level of debt.
The Congressional Budget Office predicts that federal debt held by the public will fall from 103% of gross domestic product at the end of 2021 to 106% in 2031, up from less than 40% at the time of the financial crisis.
This will make it difficult for the Fed to raise rates in response to inflationary pressures without causing the markets to collapse and precipitating a recession. Monetary tightening could trigger a perpetual cycle of financial instability, followed by further quantitative easing to support markets and support the economy.
Two questions arise. Is standardization a pipe dream? And can the dollar’s role as the world’s primary reserve currency survive amid monetary instability and fiscal excess as the United States continues to account for a declining share of global GDP?
The immediate cause of the inflationary surge is supply-side. This highlights a strange asymmetry in the relationship of central bankers with the supply.
On the one hand, Bank of England Governor Andrew Bailey is right that monetary policy cannot provide more gasoline, more computer chips, more truck drivers. On the other hand, an ultra-accommodative monetary policy has the power to create bubbles that lead to poor risk assessment and misallocation of capital. This depresses productivity growth, making the task of debt reduction much more difficult.
When US debt reached 106% of GDP in 1946, it was reduced by a combination of growth and inflation. Today, it is clear that the underlying trend growth rate of the US economy is reaching anemic levels, well below those of the immediate post-war period. This raises the possibility that inflation will have to do more debt reduction work this time around, which is an odd kind of normalization.
The required inflation will occur through what economists call second-round effects, including tightening labor markets. This is already visible and will be exacerbated by demographics as the world’s workforce begins to shrink and thus regains bargaining power.
US Treasuries are not shaken by the prospect that inflation is not transient and generates negative real income after inflation. A debt crisis is therefore clearly ahead. The same goes for any potential decline in the dollar’s reserve currency role.
With the excess global savings, there is an insatiable demand for so-called safe assets in the form of the huge open liabilities currently being created by the United States. Thus, 60 percent of the central bank’s foreign exchange reserves are still in dollar assets, with the euro zone holding only 20 percent.
As a new article by Ethan Ilzetzki, Carmen Reinhart, and Kenneth Rogoff points out, changes in the dominant global currency are rare. When they do occur, there is usually a long transition. Since the 1500s, only Spain, the Netherlands, Great Britain and the United States have seen their currencies become dominant.
The authors note, however, that while demand for safe dollar-denominated assets has exploded, the tax base backed by those assets has shrunk. Demand for safe assets, they say, may eventually exceed the fiscal capacity of the US government to support them, adding that there is no guarantee that the insatiable demand for such assets will continue.
In this debate, the lingering question is: what are the alternatives to the dollar? With China on the verge of overtaking the US economy, the renminbi, which accounts for just 2% of global reserves, is clearly a competitor. Yet many wonder if a totalitarian state with weak institutions, fragile property rights, and an interventionist way with markets can do the job.
In practice, the biggest challenge here for Powell will come if China succeeds in making the transition to a more consumer-driven economy, which would lead to lower global savings rates and higher real interest rates. This is all the more reason for the markets to wake up and recognize that the US government IOUs are very dangerous assets.