Update 545 — Powell Promotes Recovery;
Accommodates Growth and Mild Inflation
Federal Reserve Chair Jerome Powell testified this week before the House Financial Services and Senate Banking Committees. Since his last testimony in February, the economy has begun to improve, with strong GDP growth expected this year. Inflation, as expected, has increased.
He has much to say about inflation and growth and was asked about both. During the hearings, Powell said that elevated levels of inflation are expected in the early stages of an economic recovery. If Powell, whose term as Fed Chair has seven months left, were to change monetary policy course now to address inflation concerns, he knows that would run the risk of snuffing out the recovery.
Below, we review Powell’s testimony and make the case for Powell to stay the course on monetary policy but halt the Fed’s deregulatory supervisory trend, particularly if he is interested in a re-appointment.
Good weekends all,
In the coming months, the Fed will face critical decisions on monetary policy, such as when to begin tapering its asset purchases and whether to raise interest rates earlier. These actions may influence Biden’s decision to renominate Powell.
Powell Stays on Message
In his testimony, Powell stayed consistent with public statements he has made over the past several months. He said the economy is getting stronger but recognized a still-recovering labor market. Powell also noted that current levels of inflation are higher than the Fed originally expected. But he continued to assert that contributing factors are temporary and inflation will moderate later in the year.
In the House, Powell mostly faced questions about inflation and the labor market. Committee Democrats prompted Powell to explain why high inflation will be transitory and argued President Biden’s infrastructure proposals would alleviate ongoing supply chain problems. Republicans cited inflation worries.
On the Senate side, members focused more on regulatory policy, systemic risk due to climate change, and the proposed Central Bank Digital Currency. Senate Banking Chair Brown and Sen. Warren strongly criticized the Fed for its deregulatory policies, including weakening stress tests and the Volcker Rule.
The questioning by members reflected perspectives on Powell’s future. Republicans acted largely favorable toward Powell, with Financial Services Ranking Member McHenry even endorsing Powell for renomination. Powell’s dovish monetary policy notwithstanding, Republicans would support his renomination due to his conservative actions on bank regulation and supervision. Brown and Warren’s questioning indicate that progressives may be supportive of a replacement pick.
A Stay on Deregulation?
Brown and Warren captured the concern that the Fed’s recent stress tests demonstrate weaknesses in the current financial regulatory regime. If the Fed takes further deregulatory actions in the coming months, the case for President Biden nominating new individuals to key Fed positions may become clearer.
In recent years, the Fed effectively folded the Comprehensive Capital Analysis and Review (CCAR) process into the Dodd-Frank Stress Test process after removing the qualitative objections and the pass/fail quantitative assessment. The Fed had imposed restrictions on buybacks and dividends on large financial institutions during the COVID-19 pandemic to ensure financial stability. But these restrictions were lifted following each firm’s “success” during the most recent stress test. The big banks then predictably announced a frenzy of stock buybacks and dividends.
Under the Biden administration, new possibilities have opened. Quarles’ term as Vice Chair for Supervision expires in October. With that vacancy, Biden can nominate a pro-regulation Vice-Chair who can pursue more progressive regulatory policy. Top progressive agenda items include:
- Re-strengthening the Fed’s stress tests
- Reforming the Fed’s oversight of bank mergers
- Repealing the Trump-era FSOC guidance, which tied its hands on designating SIFIs
Quarles recently released the details of the models the Fed uses for the stress test, practically giving the largest financial institutions the answer to an exam. The Fed has effectively made the stress tests meaningless, giving Wall Street more relief at the expense of financial stability.
Quarles has eased regulations wherever he could, which Democrats have sounded the alarm about for years. Powell has not been as pro-deregulation as his Vice-Chair, but Democrats have become frustratedwith Powell’s resistance to strengthening rules and regulations.
A key upcoming test will be how Powell implements Biden’s recent executive order calling on the Fed to update its guidelines for bank mergers. If Powell maintains the current trajectory of deregulation in the coming months, progressives will likely push Biden harder to nominate a new Chair.
Staying the Course on Monetary Policy
Even as Republicans are fear-mongering over inflation, the Fed has kept a steady course on monetary policy. Maintaining an accommodative monetary policy in the short term will be crucial to ensure a robust economic recovery.
The Fed has continued to keep interest rates at near-zero and will continue its purchases of assets for some time, countering the narrative that inflation is a serious economic problem. The following factors indicate current elevated levels of inflation are temporary:
- Disproportionate Sectors: While the June CPI readings showed increases in prices across the board, certain sectors have risen significantly higher than others. Food prices increased by a moderate rate of 2.4 percent. Yet roughly one-third of the June CPI reading is accounted for by used car prices jumping 45.2 percent due to high demand and an ongoing computer chip shortage. Other disproportionately high jumps came from the travel industry.
- Temporary Supply/Demand Issues: As expected, pent-up demand has been unleashed with the reopening of the economy, leading to a spike in consumer spending. For sectors of the economy that shut down last year, reestablishing supply chains has been difficult, leading to more persistent supply chain problems than even the Fed originally expected. However, Powell reiterated his belief that supply problems will be resolved later in the year, bringing prices down. A notable example of this dynamic is lumber, which saw a huge price spike in the spring followed by a rapid descent in the summer.
- Tempered Market Expectations: The market barely reacted to the elevated June CPI data, indicating that most investors are following the Fed’s lead. Long-term inflation expectationsremain anchored at slightly above 2 percent — in line with the Fed’s long-term objective. Despite Republican messaging to the contrary, investors do not seem concerned that the economy is on track for a return to the prolonged inflation of the 1970s.
Powell has said repeatedly this year that the Fed will wait to raise interest rates and taper its asset purchases until economic conditions, particularly the labor market, have significantly improved. The FOMC’s June decision to maintain an accommodative monetary policy reflects the Fed’s view that the economic recovery is still incomplete. In the coming months, the Fed will face critical decisions about when to begin tapering its asset purchases and whether to raise interest rates earlier — the outcome of which could directly bear on Powell’s renomination.
The Fed currently sees a greater risk in restraining the economic recovery than that posed by inflation — and this should continue to be its outlook. Prioritizing the recovery and a return to full employment must take precedence over overblown fears of inflation.
Staying on as Chair?
With Powell’s term as Fed Chair ending in February, these Humphrey-Hawkins hearings may have been his last. What remains to be seen is whether Powell will continue his dovish and deregulatory stances in the months ahead. Recent reporting suggests that Biden is considering nominating a new Chair. The President has an opportunity to significantly reshape the Fed, with Powell’s, Quarles’, and Vice Chair Richard Clarida’s terms all ending soon and an open seat on the Board of Governors still unfilled.
The Fed’s accommodative monetary policy will be crucial to maintaining the recovery in the months ahead. But Powell’s openness to further deregulation stands in opposition to Biden’s agenda and poses systemic risk. By nominating a new vice chair for supervision or a new chair such as Lael Brainard with a stronger appetite for regulating the big banks, Biden could send a clear message that he wants a Fed that will support the economic recovery and prioritize financial stability.