Cartoon Network/ Courtesy: Everett Collection Alan Greenspan gave us his “risk management” approach to monetary policy. Jerome Powell has outlined the risks that need to be managed.
In so doing, the current Federal Reserve chairman is offering both insights into the central bank’s reaction function and guidance on future policy actions.
Read this: 3 things to watch as Fed meets on interest rates
In a speech at the annual meeting of the American Economic Association in 2004, then-Fed Chair Alan Greenspan attributed the central bank’s success in navigating a series of crises during his tenure to a “risk management” strategy. Simply put, such a strategy eschews monetary policy rules and econometric models in favor of judgment and discretion.
“This conceptual framework emphasizes understanding as much as possible the many sources of risk and uncertainty that policy makers face, quantifying those risks when possible, and assessing the costs associated with each of the risks,” Greenspan said. “Policy practitioners operating under a risk-management paradigm may, at times, be led to undertake actions intended to provide insurance against especially adverse outcomes.”
In recent months, Fed Chair Jerome Powell has emphasized the Big Three risks that could lead to such “adverse outcomes:” slowing global growth, trade-policy uncertainty and persistently low inflation. Those risks were the drivers behind the 25-basis-point rate cut on July 31, a move that is likely to be repeated on Wednesday.
So how does that risk assessment stack up using the Big Three as a guide?
Risk #1: Global slowdown
Slowing global growth is still a risk; a big risk. Economic growth in the eurozone slowed to 0.2% (0.8% annualized) in the second quarter. Germany, the eurozone’s largest — and world’s fourth largest — economy, reported a 0.1% decline in second-quarter real gross domestic product. growth. The third quarter is looking bleak for the manufacturing powerhouse due to an ongoing slump in industrial production.
The U.K. economy contracted by 0.2% in the second quarter, and its exit from the European Union, whatever form it takes, is expected to depress economic growth further. Japan seems stuck in permanently slow-growth mode.
Even China’s economy is showing signs of fatigue, with real GDP rising 6.2% in the second quarter from a year earlier, the slowest pace in almost three decades. On Monday, China reported the weakest year-over-year growth in industrial output in August since 2002.
So “slowing global growth” is still a risk factor. Check.
Risk #2: Trade policy
The tariff war looks to be getting a reprieve, although that will not reduce trade-policy uncertainty, given President Donald Trump’s volatile nature and preference to use tariffs as a cudgel in international disputes.
Following the imposition of a 15% tariff on about $112 billion of mostly consumer goods on Sept. 1, Trump decided to delay for two weeks the tariff increase to 30% from 25% on $250 billion of Chinese goods that was scheduled to take effect Oct. 1, in deference to the 70-year celebration of the People’s Republic of China.
China, in turn, exempted some U.S. goods from tariffs and reportedly made its first large purchases of soybeans and pork in months.
A final tranche of 15% tariffs on some $160 billion of Chinese goods is scheduled to go into effect on Dec. 15 to spare the consumer higher prices during the Christmas shopping season. (No, China doesn’t pay the tariffs.)
China isn’t Trump’s only target. The president has threatened tariffs on an array of European imports, including automobiles, wine and luxury goods. His apparent annoyance with the European Central Bank for lowering interest rates, which weakens the euro EURUSD, +0.4635% and gives European companies a trade advantage, may rankle him enough to seek revenge through tariffs: his favored policy strategy, be it to reduce the U.S. trade deficit or restrict immigration from Mexico
The U.S. and China are scheduled to resume high-level trade talks in Washington in early October. Don’t hold your breath waiting for a major trade deal where China agrees to open its economy to all forms of investment, curtail subsidies to favored industries, and cease unfair trade practices.
Tariffs have depressed global trade flows and induced manufacturing recessions in several developed economies, including the U.S. Those adverse effects will continue to ripple through the world economy, so from the Fed’s point of view, a temporary truce between the U.S. and China does nothing to alleviate the destructive effects of tariffs already in place or to mitigate “trade policy uncertainty.”
You can put a check mark next to “trade policy uncertainty” as an ongoing risk.
Risk #3: Low inflation
That leaves persistently low inflation. The core consumer price index, which excludes food and energy, rose 0.3% for the third consecutive month in August. That pushed the year-over-year increase up to 2.4% for only the second time since 2008.
While the surge in medical-care costs, the main driver of the outsized increase, may have been a function of a measurement quirk that distorts the CPI compared to the Fed’s preferred inflation gauge — the personal consumption expenditures price index — it bears watching. The core PCE price index, which has been trending lower for a year, rose 1.6% in the year ending July.
The Fed is considering a new policy that would tolerate inflation above its 2% target to offset years of undershoot as part of a makeup strategy. It remains to be seen how policy makers would react if and when they saw the whites of inflation’s eyes instead of theorizing about inflation offset.
The huge spike in oil prices CL.1, -5.14% following Saturday’s attack on Saudi Arabia’s oil processing facilities that took out half of the kingdom’s production is likely to have ripple effects for months.
Such a negative supply shock — implying lower output and higher prices — is not something central banks are equipped to address as their policy tools are designed to affect aggregate demand.
While persistently low inflation may be less of a risk in the short term, it may be offset by any negative effects the oil spike has on business and consumer confidence and any additional threats it poses to global growth, even once oil production is fully restored.
For the moment, then, you can put a question mark next to “persistently low inflation.”
Now, as long as the U.S. economy is “in a good place,” as Powell and his minions are wont to say, risk management will be the order of the day. Watch the risks to determine the management, or policy, strategy.
If and when the U.S. consumer, who has been powering the economy and shows no sign of fatigue, decides to pull back, all bets are off. The 75-basis-point “mid-cycle adjustment” that many economists expect by the end of the year — similar to the Fed’s response in 1994-1995 and in 1998 — will yield to a full-blown easing cycle.
At that point, risk management will give way to “whatever it takes” at a time when global central banks may not have the resources needed to deliver on that promise.
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