Fed Chairman Powell: A Gentle Beginning, But What Lies Ahead?

Summary

• Jerome Powell experienced his first visit to the Congressional hallways as Fed Chair and came away from the experience without any beatings or scars.
• The uncertainties that hang over discussions of future monetary policy seem to center around the major changes that have been made to the government's fiscal policy.
• The velocity of money has declined significantly over the past nine years and this has contributed to modest economic growth and unexpectedly slow rates of inflation.
• But, substantial liquidity exists within the banking system and the real unknown relates to the concern about whether or not the massive governmental stimulus might stir up the use of this liquidity.

New Federal Reserve Chairman Jerome Powell did his first performance in the role before Congress on Tuesday.

All indications are that he did just fine.

Here is the link to his prepared remarks. His position on the economy is pretty optimistic and his feeling is that inflation will move up to the Fed's targeted rate of 2.0 percent this year.

The basic takeaway from this session is that it is quite likely that we will see four increases in the Fed's policy rate of interest this year and not just three as originally signaled.

This optimism did impact the financial markets as interest rates rose and the stock market declined. But, that was just for Tuesday.

There were only two comments in Mr. Powell's presentation that drew my attention.

The first one is on the technical end of the spectrum and was interesting to me because it was about a new argument that I was not familiar with. Mr. Powell, when talking about the labor market, commented on the fact that the labor force participation rate had "remained roughly unchanged, on net, as it has for the past several years."

He argued that this steadiness was a good thing and "a sign of job market strength, given that retiring baby boomers are putting downward pressure on the participation rate." This was a good thing because of the changing demographics of the labor market.

The second comment he made - and, he made it twice in his prepared text - was that "fiscal policy is becoming more stimulative." Furthermore, he added, "foreign demand for U.S. exports is on a firmer trajectory."

This is good - while at the same time concerning. Good because these two factors add more demand into the economy, hopefully, creating faster economic growth. Concerning because of the impact the stimulus might have on accelerating inflationary pressures.

Mr. Powell described these changes in this way: "While many factors shape the economic outlook, some of the headwinds the U. S. economy faced in previous years have turned into tailwinds."

The Federal Reserve is obviously concerned about the contribution that the "new" fiscal policy will make toward economic growth - and/or inflation - because Federal Reserve vice chairman for supervision, Randal Quarles gave a speech on Monday that also addressed a concern about what the impact of the government's tax cuts and spending plans would be.

According to the New York Times, Mr. Quarles' "remarks suggested the Fed is willing to wait and see what happens."

Mr. Quarles said, "I will be carefully watching indicators of economic activity and inflation and assessing the degree to which activity appears to be pushing up against the constraints of the economy, as opposed to being a reflection of the expansion of those constraints and the growth of the potential output of the economy."

In other words, the Federal Reserve has little idea about how the new fiscal stimulus will impact the economy and therefore, has little idea of exactly what will be required of its monetary policy.

The monster in the closet, so to speak, is hyperinflation. Could the aggressive fiscal stimulus of the Trump administration, something that has been largely absent over the past nine years, set off a cumulative burst of inflation that has been hiding during the current recovery.

The Federal Reserve started to become very aggressive in the fall of 2008 as it combatted the disarray in the financial sector of the economy, just previous to the start of the Great Recession.

For example, in the late summer and early fall of 2008, the monetary base, the foundation of the money stock and credit expansion, was around below $850 billion and the excess reserves in the banking system amounted to a little over $12 billion.

In January 2009, the monetary base came in at $1,711 billion, double the August figure and excess reserves had risen to close to $800 billion.

By May 2011, the monetary base had more than tripled to $2,567 billion and excess reserves were around $1,605 billion.

Never, in American history, had the monetary base risen so rapidly, to such large figures. Never had the banking system had so much liquidity.

During this time, many economists believed that accelerating inflation was assured - and that hyperinflation was just around the corner. Remember, inflation, everywhere and every time, is a monetary phenomenon.

Of course, as we now know, rapid inflation, let alone hyperinflation, did not manifest itself.

The economy grew, but at a very modest pace during the following recovery. For the eight and one-half years of the current recovery, the U.S. economy grew by only a 2.2 percent compound rate of growth. This was very modest by past standards.

Inflation continued to remain docile during the recovery period up through 2016. In 2012, the rate of increase in the GDP price deflator was 1.9 percent. In 2015 and 2016, it was 1.1 percent and 1.2 percent, respectively.

What we saw during this time period was a massive decline in the velocity of circulation of the money stock, the rate at which the money stock, on average, turns over during a period.

In 2008, the velocity of the M2 measure of the money stock was right around 2.0. Currently, the M2 velocity measure is about 1.45. This is a huge decline.

What can this decline be attributed to? My analysis has led me to believe that this decline in monetary velocity is due to the increased financialization of the economy as more and more financial innovation took place in the last thirty or forty years. Money - credit - is going into the acquisition of assets and not into the purchase of consumption goods or physical investments.

For example, financial engineering is resulting in corporations buying back stock or paying higher dividends rather than spending proceeds. Asset prices rise, consumer prices don't rise.

What is uncertain about the future is whether or not this financial engineering is going to continue to dominate the scene or will the fiscal stimulus - the move to deregulate financial institutions - and the reduction in regulatory pressure result in an acceleration in capital investment and further increases in consumption expenditures.

This is the world that Mr. Powell is walking into. I think that it is right to be concerned about the situation. There are lots and lots of liquidity out there and if interest rates really do rise significantly, the banks might actually begin to reduce their excess reserves and start lending again for productive purposes.

If that happens, then watch out because the velocity of circulation of money might begin to rise and with it more rapid inflation.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.