Powell vs. Greenspan: Who's Right? "Hands-Off" Or "Hands-On" Policy To Confront Cyclical Inflation
Submitted by Joseph Carson, former chief economist at Alliance Bernstein
Federal Reserve Chair Jerome Powell in 2021 faces a similar challenge that former Fed Chair Alan Greenspan faced in 1994. Fast growth as the economy re-opened triggered substantial cyclical inflation pressures, somewhat similar to 1994 when headwinds from tight credit and balance sheets strains faded. Yet, Powell's policy response to the inflation challenges has been markedly different than Greenspan's.
Powell has employed a "hands-off" approach, maintaining the overly accommodative monetary policy stance, thinking the inflation surge will prove to be temporary. The inflation results for all of 2021 are not in, but consumer price inflation in the first six months (3.6%) exceeded what occurred in the twelve months of 1994 (2.6%).
In 1994, Greenspan used a "hands-on" approach, quickly and rapidly tightening monetary policy, arguing that letting the pipeline inflation pressures go unchecked was too risky. In 1994, pipeline inflation pressures measured by the producer price index of core intermediate materials rose 5.2%. In the first six months of 2021, those prices have increased 14.7%, nearly three times faster.
Greenspan's preemptive policy was successful as pipeline pressures never percolated to the consumer level. The headline and core CPI ended 1994, advancing 2.6%, some 20 to 50 basis points below the inflation rates of 1993.
Powell acknowledges that the uptick in 2021 inflation rates has been far more significant than the Fed expected. Yet, Powell takes comfort in that longer-term market inflation expectations remain well-anchored, and the drop in long bond yields shows little market fear of sustained inflation.
But people's spending behavior shows that inflation expectations are on the rise. A 10% increase in used car and truck prices in early 2021 did not deter buyers as prices rose an additional 20% in Q2. Nor has a record climb in house prices stopped people from buying. Aren't these examples of a rise in inflation expectations?
The recent bond market rally is puzzling. But it is worth noting that in 1994 a surprising drop in ten-year bond yields (over 50 basis points) occurred in the middle of the Fed's tightening cycle. Back then, analysts and investors viewed a significant increase in business inventories as a sign that demand was peaking and the Fed tightening cycle would soon be over. That proved to be a big mistake.
Greenspan said the inventory build is intentional as sharp increases in order backlogs forced firms to buildup stock levels to protect future production schedules. Following that assessment of the inventory situation and growth outlook, Greenspan delivered an additional boost of 175 basis points in the federal funds rate over the next six months, sending 10-year bond yields surging higher by over 100 basis points. The 1994 bond market reversal shows that not all bond market rallies are an accurate predictor of the future.
At the press conference following the April 27-28 Federal Open Market Committee (FOMC) meeting, Powell stated that "the economy is a long way from our goals," and it's not time to begin discussing the process of even talking about tapering asset purchases. Three months later, press reports say that the Powell-led Fed is accelerating the tapering discussions at the July 27-28 FOMC meeting. If Powell can reverse course on asset purchases in three months, he could flip on interest rate policy quickly as well.
A "hands-off" policy is a short-term friend to finance until it isn't, whereas a "hands-on" is a long-term friend as it attempts to limit the scale of the inflation cycle. Greenspan's "hands-on" policy worked, and early results indicate Powell's "hands-off" isn't. How long will it take before investors realize Powell will eventually need to follow Greenspan's plan?
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