The Federal Reserve’s worrying slide from villain to pushover

Nicholas Spiro says the rise of populism and protectionism has made central banks’ jobs a lot harder. US Federal Reserve chairman Jerome Powell has just signalled a dovish tilt, and is being accused of caving in to financial markets

Nicholas Spiro

Published: 2:00am, 1 Feb 2019

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Spare a thought for Jerome Powell, the chair of the US Federal Reserve. After his overly hawkish tone was blamed for the dramatic sell-off in the stock market last December, he has since been treading a fine line between placating financial markets and responding to the continued strength of the US economy.

While investors have been hanging on central bankers’ every word since the 2008 financial crisis, as successive rounds of quantitative easing boosted asset prices and suppressed volatility, Powell faces intense scrutiny. Not only is the Fed the world’s most influential central bank, it is the most advanced among its main peers in normalising monetary policy in the face of a slowdown in the global economy.

Powell, who took the reins of the Fed a year ago, has struggled to communicate the central bank’s policy stance. At his press conference on Wednesday, following the Fed’s decision to leave its benchmark interest rate unchanged, he conceded the case for raising rates further had weakened due to the increasing number of global headwinds. While investors cheered the dovish tilt, Powell is now being accused of caving in to markets.

Meanwhile, the European Central Bank is in an even tougher spot. Last week, Mario Draghi, the ECB’s president, failed to provide a credible explanation as to why it ended its quantitative easing programme last December – and is still keeping open the option of raising rates later this year – when growth in the euro zone has dropped to a 5½-year low, with manufacturing output in Germany, the bloc’s largest economy, in contraction territory. Many investors fear a policy mistake is brewing.

Yet while the big central banks have become a source of intense volatility as the withdrawal of stimulus has gathered pace in the past year, much of the recent turbulence in markets stems from factors beyond their control.

One of the most important ones is political risk, notably the growing influence of populist and protectionist policies since Donald Trump became US president and Britain voted to leave the European Union, strengthening the hand of nationalist parties across the bloc which oppose plans for further integration.

In the US, the combination of Trump’s sweeping tax cuts and his trade offensive against China has made the Fed’s job a lot harder. While providing a significant boost to the US economy last year, Trump’s fiscal stimulus has fuelled inflationary pressure and, more worryingly, added to the country’s unsustainable debt burden.

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According to a report published by the US Congressional Budget Office on Monday, if fiscal policy continues on its current trajectory, government debt might reach 105 per cent of economic output in 2029, breaking the record set after the second world war.

While such profligacy puts pressure on the Fed to keep tightening policy, the trade war has begun to take its toll on the US economy, squeezing many companies’ profit margins.

The budget office report warns that trade tariffs will shave an average of 0.1 per cent off the US’ annual growth rate through to 2029. What is more, the recent government shutdown – which was mostly of Trump’s own making – has sapped consumer confidence.

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US political risk is likely to intensify in the coming months as the investigation into links between Russia and Trump’s presidential campaign concludes, potentially leading to calls for Trump’s impeachment.

In the euro zone, the ECB has been shouldering the burden of economic recovery in the bloc ever since Draghi pledged in 2012 to do “whatever it takes” to avert a break-up of Europe’s single currency area.

Persistent divisions between a German-led group of wealthy member states wary of bailing out vulnerable southern European countries and a French-led one reluctant to cede economic sovereignty have stymied plans for closer integration within the bloc.

While these rifts were less visible in recent years as cheap money stabilised bond markets and revived growth, the end of the ECB’s quantitative easing programme threatens to reignite deep-seated political tensions in the euro zone. Italy, the bloc’s third-largest economy that seems to be slipping back into recession, is the battleground that will determine whether the current slowdown in Europe blows up into another crisis.

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And unlike in 2012, Germany now has an influential nationalist party, Alternative for Germany, that is bitterly opposed to the bloc’s ultra-low borrowing costs, making the ECB’s job devilishly difficult.

Still, at least the Fed is now perceived by markets to be acting prudently, having just put its rate-hiking cycle on hold. The timing, however, is unfortunate. For the past several months, Trump has been castigating Powell for raising rates too quickly.

While the Fed’s independence is not in question, it is troubling that Trump, the world’s populist-in-chief, is having the last laugh.

Nicholas Spiro is a partner at Lauressa Advisory

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