Yellen Smoothly Passes the Baton

The Federal Open Market Committee (FOMC) voted unanimously to maintain the current short-term interest rate target at 1.25-1.5%, after raising the target in December. The statement was slightly more hawkish than last month, noting the increase in inflation expectations since the last meeting. Everything from stronger growth at home and abroad to debt-financed tax cuts have raised expectations for inflation over the last six weeks. The FOMC affirmed its commitment to continue raising rates at a gradual pace this year. Consistent rate hikes have moved from being considered improbable to all but assured.

Today's meeting marked the last that Chair Yellen presides over. She began her tenure with the Federal Reserve forecasting lower unemployment and stronger economic growth. Now that forecast is a reality. In response, Yellen was able to start the process of exiting crisis-era policies without disrupting financial markets and smoothly hand the baton to the new chair, Jerome (Jay) Powell.

The challenge for Chair Powell will be to wade further into the uncharted waters of unwinding the crisis-era measures of near-zero interest rates and large asset purchases without creating waves in the financial markets. Reductions in the Fed's bloated balance sheet are scheduled to accelerate over the course of 2018. The shift comes at the same time that the Department of Treasury announced the need to issue more debt. The deficit is expected to easily cross one trillion dollars in fiscal year 2019, if not sooner.

The risk is that Treasury bond yields move up faster than market participants and those on the Fed expect. The result would boost interest expenses for the public and private sectors, eventually sowing seeds for the next recession. Indeed, former Fed Chair Alan Greenspan today voiced his concern publicly (in a Bloomberg interview) that we are facing bubbles in both the bond and equity markets. Greenspan underscored that the risk of a bubble bursting is greater in the bond market than in the stock market. His biggest concern is another stagflation scenario down the road.

I am not as worried about that in the near-term but former Chair Greenspan's warnings should be taken seriously. The only real way out would be a major surge in productivity growth, which does not appear likely because older, more experienced workers are retiring out of the labor force. This is acting as an anchor on productivity growth.

Look for Chair Powell to raise rates at his first, official policy-setting meeting in March. By then, we should have seen enough of a warming trend in wages and inflation for most on the Fed to feel comfortable with such a move. Powell could, however, receive pushback and even a formal dissent from President Raphael Bostic of the Atlanta Fed who has sided more often with the doves among the leadership.

Chair Powell is known for his easy speaking style and deep understanding of financial markets. He will be reluctant to voice publicly the concerns that he and his colleagues have about the froth in financial markets. The Fed has very few tools with which to contain asset price bubbles without violating the Congressional mandate to promote full employment and stable prices. Previous attempts by the Fed to jawbone financial markets into place have failed.

Bottom Line
The Fed starts the year with both a plan and the credibility to raise rates and reduce the balance sheet. The challenge will be to continue to do so without causing much disruption in financial markets. Chair Powell may look back on his time as a Fed Governor fondly.

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