Considering Fed Action in 'Messy' Times

Article ID: 707774

Released: 8-Feb-2019 10:05 AM EST

Source Newsroom: University of Virginia Darden School of Business

By Dave Hendrick

As January draws to a close, the U.S economy finds itself in uncharted territory, with conventional measures of strength such as the low unemployment rate and increasing wage growth juxtaposed with a topsy-turvy stock market, the longest-ever U.S. government shutdown and a U.S. president openly pillorying actions of the Federal Reserve Board.

Against the unusual backdrop, University of Virginia Darden School of Business Professor Frank Warnock discussed market conditions and economic indicators heading into 2019, in a session organized by Eileen Cowdery (Class of 2019). 

WHERE ARE WE NOW

“To characterize the current situation, we have historically low unemployment and the economy has been doing, on average, pretty well,” said Warnock, who worked as a senior economist at the Board of Governors of the Federal Reserve System before coming to Darden, where he teaches in the Global Economies and Markets area. “Any measure of where we are relative to the economy’s full employment level has been indicating we are beyond capacity. Historically, when this happens we have inflation.”

In an effort to keep inflation in check, the Fed has been gradually tightening its monetary policy while also taking the opportunity to begin to reduce the size of its massive balance sheet by selling some of the Treasury bonds it accumulated during the Great Recession.

“That’s the scenario, but then things get messy from there,” said Warnock.

WHERE WE MIGHT GO

Warnock noted, for instance, that the notion of full employment is an estimate, not an observable phenomenon, and yet Fed actions based on the estimate have potentially dramatic consequences.

  1. If the Fed is correct and the economy is strong, running at or beyond full employment, and it continues to raise interest rates, expectations of equity returns will need to adjust. Some industries — shale mining, for example — may no longer be profitable in a world of high borrowing costs. In that case, “It would be a different world than the super-low-interest-rate world we’ve seen for the past decade,” Warnock said. “It doesn’t mean it’s bad, it’s just different, and firms and investors will have to adjust.”
  2. If the Fed is wrong about the strength of the economy and continues to raise interest rates, tightening too much, it could cause a recession. And, indeed, most U.S. recessions occur after the Fed tightens monetary policy.
  3. A third scenario: If the economy is as strong as the Fed appears to believe but President Trump succeeds in pressuring Fed Chair Jerome Powell to hold off or slow down tightening monetary policy, the result could be high inflation (and sharply higher borrowing costs). We’ve seen this play out before, in the 1970s when Richard Nixon pressured Fed Chair Arthur Burns in what became became known as the Great Inflation.

Whether the Fed keeps a lid on interest rates or begins to raise them, Warnock doesn’t expect any sudden moves. 

Said Warnock: “What does the Fed normally do? They make small changes in banks' borrowing costs and then, because how that will work through the economy is uncertain, they step back, observe and repeat if necessary. You should expect to see small steps from the Fed.”

About the University of Virginia Darden School of Business

The University of Virginia Darden School of Business delivers the world’s best business education experience to prepare entrepreneurial, global and responsible leaders through its MBA, Ph.D. and Executive Education programs. Darden’s top-ranked faculty is renowned for teaching excellence and advances practical business knowledge through research. Darden was established in 1955 at the University of Virginia, a top public university founded by Thomas Jefferson in 1819 in Charlottesville, Virginia.

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