Jerome Powell risks Alan Greenspan’s fate

History did not judge former Federal Reserve Chairman Alan Greenspan kindly for his role in the 2008 U.S. housing and credit market bust that ushered in the Great Recession. Jerome Powell, the current Fed chairman, now risks the same fate.

He does so by continuing to expand the Fed’s already bloated balance sheet and by keeping interest rates ultra-low at a time that there is every indication that we are in the midst of a global “everything” bubble that is larger and more pervasive than was the earlier U.S. housing market bubble. He is also doing so by keeping the Fed’s pedal to the metal at a time that the U.S. economy is receiving an unprecedented amount of budget stimulus even when it is showing every sign of recovering strongly from the pandemic. 

William McChesney Martin famously declared that the Fed’s primary role was to remove the punchbowl just as the party was warming up. Alan Greenspan chose to ignore that advice in the run-up to the U.S. housing market bust. He chose to do so even at a time that the U.S. housing market was experiencing its largest boom in the past 100 years. By so doing, he set up the conditions for the deepest post-war U.S. economic recession up to that date.

Powell seems to be repeating Greenspan’s mistake of inflating asset and credit market bubbles even though there are the clearest of signs of considerable excess in those markets. He is currently doing so not simply by keeping interest rates at ultra-low levels. He is also doing so by committing the Fed to continue buying $120 billion a month in U.S. Treasury bond and mortgage-backed securities until the Fed sees actual signs of higher inflation. 

In keeping the Fed’s monetary spigot wide open, Powell does not seem to be fazed by the fact that U.S. equity valuations are now at the lofty levels they were at on the eve of the 1929 stock market crash. Nor does he seem to be bothered that despite their very weak economic fundamentals, the emerging market economies and the highly leveraged advanced economy corporations can borrow at interest rates not much higher than those at which the U.S. government can borrow.

When it comes to his currently overly sanguine attitude toward inflation, history is like to chastise Powell for ignoring two of Milton Friedman’s basic monetary policy lessons. The first is that inflation is always and everywhere a monetary phenomenon. The second is that monetary policy operates with long and variable lags.

Had Powell heeded Friedman’s lesson about inflation as always being a monetary  phenomenon, he would not be nearly as relaxed as he now seems to be about the prospect of inflation returning. In particular, at a time that the U.S. broad money supply is growing by around 30 percent, by far its fastest rate in the past 50 years, he might have been more concerned that there is considerable pent-up demand in the U.S. economy that is likely to be released once the pandemic subsides. Coupled with an unprecedented amount of budget stimulus, that pent-up demand is almost certain to give rise to higher inflation later this year as former Treasury Secretary Larry Summers keeps warning us.

Had Powell heeded Friedman’s warning that monetary policy operates with a long lag, he would not be as reluctant as he now seems to be to start tightening monetary policy by dialing back the Fed’s aggressive bond buying program and by signaling a willingness to raise interest rates. Instead, by waiting for clear signs of inflation to appear, Powell is more than likely to have waited too long to prevent another period of unwelcome inflation. 

Hopefully, this time around will be different and a Federal Reserve behind the curve will not lead to higher inflation or to the disruptive bursting of an asset price and credit market bubble. But I would certainly not recommend betting the farm on such a favorable outcome. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.