The Jerome Powell Bust

Jerome Powell will likely be the next chair of the Federal Reserve.  He will take over from Janet Yellen at the end of January 2018.  Whether Yellen knows it or not, her exit will be a blessing for her.  She should be quietly thanking Donald Trump.

Ben Bernanke took over as Fed chair in 2006.  He inherited a mess, but it wasn’t known at the time.  Even for those who knew there were underlying problems in the economy, most didn’t expect the drastic nature of the housing bust, financial meltdown, and overall recession.  There is absolutely nothing Bernanke could do to stop the bust from coming.  Perhaps he could have delayed it a little bit through monetary inflation, but it likely wouldn’t have postponed it for long.

Bernanke was a really bad Fed chair, but not because we had a severe recession and financial crisis.  He was a bad Fed chair because of his response to the financial crisis.  To the bankers and others who were bailed out, Bernanke was not a bad Fed chair.

He presided over the greatest monetary expansion in the history of the Federal Reserve.  He approximately quintupled the size of the adjusted monetary base.  But due to the piling up of excess reserves by banks, coupled with continued fear in the markets, consumer price inflation never really took off.  The same can’t be said for asset prices as reflected currently by the big valuation increases in housing and stocks.

While Yellen came into office as an Obama-appointed Keynesian, she has actually be relatively subdued.  She wrapped up QE3 in her first year and has not expanded the balance sheet since then.  While it took her a while, she actually just started the Fed’s program of reducing the balance sheet, even if slowly.

If we are to believe the Austrian Business Cycle Theory, the Fed’s loose monetary policy from 2008 to 2014 caused malinvestments (misallocated resources).  Therefore, resources are not all currently being used in an efficient manner in accordance with consumer demand.  At some point, these malinvestments will be exposed as such, and there will be a correction.  The Fed’s tight monetary policy will put further pressure on the situation.

Much like Bernanke, Jerome Powell is going to inherit a mess.  He will be stuck with the malinvestments that started under Bernanke.  Powell will likely oversee the bust phase.  Unfortunately, he is probably like Bernanke in other ways in that he will likely resort to significant monetary inflation when faced with a crisis.

When Donald Trump was campaigning for president, he mentioned a few times that there were bubbles in the economy.  As soon as he became president, he started taking credit for the boom.  This was stupid, but politicians just can’t help themselves.  Since Trump has been taking credit for the little boom, he will own the bust.

There will be many bubbles that pop.  Stock prices will take a huge hit.  Housing will take a hit in many areas.  Some fads like cryptocurrencies – particularly Bitcoin – will take a hit.  Some commodities will take a hit, although gold is less certain.

Assuming we don’t see a significant pickup in price inflation, government bonds will probably not go bust in the recession.  That bubble will get blown bigger in the short run.  Investors still see U.S. government debt as a safety vehicle.  They will seek to lock in long-term rates.  Therefore, expect interest rates to actually fall in the next recession.

The one bubble we need to pop more than anything is the bubble that is Washington DC.  We need a drastic reduction in the size and scope of the federal government.  Unfortunately, the only way we are likely to see this happen is to have much higher interest rates where the Fed can no longer intervene due to fears of rampant inflation.  As long as the Fed is allowed to step in as a buyer in the bond market, then the government bubble will probably keep going.

While the Fed has not been a net buyer of government debt for over three years now, it still stands there ready to act if needed.  This helps to support the bond market, even when the Fed is not actually buying.

Jerome Powell will be little different from previous Fed chairs.  But the situations may differ, especially in size.  The current system of Fed interference and massive deficits will come to an end eventually.  We know this because it isn’t sustainable over the long run.  When the next recession hits, the annual deficit will quickly balloon over a trillion dollars.  At some point, the debt will become unmanageable.

There is a tendency for us to let our guard down, partially due to the fact that we can’t constantly be on high alert.  When times are good, or at least decent, then we think they will just keep humming along.  But one day, something will happen and the dominoes will start to fall.  We don’t know when that will be, but we should at least not be surprised when the day comes.  Neither should Jerome Powell.

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