Jerome Powell’s second term will be more challenging
US President Joe Biden has decided to maintain stability at the central bank by re-nominating Jerome Powell as chairman of the Federal Reserve. Although some influential members of the Democratic Party were against the nomination, Mr Powell’s confirmation is expected to be as smooth as last time. Mr Powell has been criticised, including for not acting against climate change, though it’s not very clear as to how central banks are expected to respond to the climate change challenge, which is essentially a responsibility of fiscal authorities. Mr Biden has shown confidence in a Republican appointed by his predecessor to maintain stable leadership at the Fed. This should help boost market confidence and underscore the shift in approach at the White House. Mr Powell was vehemently attacked by Donald Trump for not following what he believed was the right policy.
In terms of policy, Mr Powell will face a different set of challenges in his second term. The US economy was steadily expanding after it recovered from the financial crisis. The unemployment rate was at a multi-decade low and inflation was mostly undershooting the target of 2 per cent. But the pandemic completely changed the policy environment. The pandemic-induced shutdown resulted in a contraction. While the inflation rate came down, unemployment went up sharply. Mr Powell’s Fed responded by cutting interest rates and buying assets from the market to infuse liquidity at an unprecedented pace. The Fed balance sheet has more than doubled since the beginning of 2020. It also supported trillions of dollars worth of spending by the government. As a result, the economy recovered sharply as it was allowed to open up and has pushed the inflation rate way above the Fed’s comfort level. The consumer price index in October, for example, went up by 6.2 per cent — the highest in over three decades. The unemployment rate has fallen below 5 per cent and wages are rising fast.
Although the Fed has decided to reduce the amount of its asset purchase, Mr Powell believes that higher inflation is transient and a result of disruption in supply chains. However, some market participants expect that the Fed might have to raise rates at a faster pace than currently anticipated. It is possible that Mr Powell is reading the situation correctly and inflation would come down in the coming quarters. Commodity prices, for instance, seem to be stabilising. However, what is not clear is how quickly the inflation rate will decline to the Fed’s target of 2 per cent, and how it will deal with the possible delay. Since the Fed has moved to average inflation targeting, it’s not entirely clear to financial markets how long it would allow the inflation rate to remain above 2 per cent and up to what level. How will the Fed react if the rate settles above the target?
Mr Powell, thus, will have to deal with a challenging policy environment, which would be far more demanding than cutting rates and flooding the system with liquidity. Clear communication will be the key in this context as the impact of the Fed’s action will not be limited to the US. Increased uncertainty or quicker than expected tightening of financial conditions could increase volatility in global financial markets and impede economic recovery. With large foreign exchange reserves, fortunately, India is better placed to deal with the consequences of Mr Powell’s policy response.