4 July 2020

Fed’s Powell On Capital Hill

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Federal Reserve Chairman Jerome Powell heads to Capitol Hill Tuesday for his second pair of hearings since becoming the central bank’s new leader in February.

He starts Tuesday before the Senate Banking Committee, which releases his testimony when the hearing begins at 10 a.m. EDT. He returns Wednesday to answer questions from the House Financial Services Committee, also starting at 10 a.m.

His remarks are unlikely to surprise. Not much has changed since he said at his press conference June 13 that “the U.S. economy is in great shape.” Fed officials voted that day to raise interest rates and pencil in two more increases this year. Still, he will be pressed for answers on an array of issues. Here’s what to watch:

Trade Tensions 

Fed officials are growing more nervous about rising trade tensions, according to minutes of their June meeting released last week. Watch for how Mr. Powell responds to questions about the implications for the U.S. economy and Fed policy.

He is likely to repeat that it is still too early to know—with many threats still in the air and considerable uncertainty about what proposals will go into effect. And he has resisted requests for comment on specific policies that the Fed doesn’t set, including fiscal and trade policy, because he believes it weakens the central bank’s case for political independence in setting monetary policy.

Nevertheless, Mr. Powell could be pressed on how the Fed would respond if new trade measures hurt U.S. economic growth, which might call for lower rates, while also boosting inflation, potentially requiring higher rates. He said in a radio interview last week such a situation “would be very challenging.”

Regulatory Debate 

Mr. Powell could face hostile questioning from Senate Democrats who opposed steps the Fed took to relax certain financial regulations. In a letter last week, Sens. Sherrod Brown of Ohio and Elizabeth Warren of Massachusetts pressed Mr. Powell for details about the unusual treatment of Goldman Sachs and Morgan Stanley in recently conducted stress tests.

Mr. Powell has generally defended most of the postcrisis financial regulations, and he could characterize recent changes as simplifying rather than relaxing them.

Watch to see if he goes further and discusses how the Fed might adjust either regulatory or monetary policy if officials see a rising risk of financial instability.

Job Growth: A Virtuous Cycle? 

The June employment report showed solid hiring and an uptick in the unemployment rate, to 4%, from 3.8% in May, because of a surge of entrants into the labor force. If this could be sustained, the economy would be in a sweet spot for the Fed.

Watch to see whether Mr. Powell thinks more workers can be drawn in off the sidelines. If he does, that would allow the Fed to continue raising rates very gradually without worrying that low unemployment will send inflation too high.

Mr. Powell has made clear his uncertainty about the unobservable variables that are particularly important in setting monetary policy. One example is the so-called natural rate of unemployment, the level which neither spurs nor slows inflation. Falling below that level could lead to unsustainable price pressures.

Mr. Powell’s caution about such unobservable variables could signal a willingness to accept a slower pace of rate increases than textbooks might dictate.

Overheating Trade-offs

On the other hand, Fed economists are looking for signs that the inverse relationship between unemployment and inflation, dormant in recent decades, might quickly awaken once the jobless rate falls below a certain level.

In the 1960s, Fed officials adopted an “overly optimistic view of the natural rate of unemployment,” according to a 2011 paper co-wrote by John Williams, who is now the New York Fed’s president.

Watch for how Mr. Powell rates the prospect of a similar mistake by officials today. A related concern is how much to worry that instead of unsustainable price pressures, a period of strong growth and low unemployment might fuel asset bubbles or other sources of financial instability.

The Shrinking Bond Portfolio

Movements in short-term money in the spring prompted officials to tweak the way they set interest rates in June. Fed officials think upward pressure on their benchmark federal-funds rate stemmed from market dynamics unrelated to their program to shrink the central bank’s $4.3 trillion bond portfolio. This process is draining bank deposits at the central bank, called reserves, which at some point probably will place upward pressure on the fed-funds rate.

Mr. Powell could face questions on how long the portfolio-reduction process will continue. He probably won’t signal any changes here because the Fed has set a high bar to alter course.

But the uncertainty over what is going on could prompt Fed officials to open a debate over how to operate monetary policy in the future—whether to continue with the current approach or revert to the one used before the financial crisis.

Look to see if Mr. Powell offers any hints on this front. Maintaining the current framework for setting rates would involve having lots of reserves, which would require an early end to running down the portfolio. Returning to the old approach would mean fewer reserves and allowing the portfolio to wind down for longer.

Click here for the original article from The Wall Street Journal.

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