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Greenspan Warning: Stagflation Ahead

Irwin M. Stelzer

Jay Powell and Donald Trump combined last week to shake investors to their core.

New Federal Reserve Board Chairman Powell tried to keep his first congressional appearance since taking the job a bland affair. He failed.

Donald Trump expected a positive reaction to his announcement that he is planning to levy tariffs on steel and aluminum. Instead, he watched share prices tumble hundreds of points as investors decided to run for cover from Powell’s monetary policy and Trump’s trade war.

And to add to all of this, the inventor of the phrase “irrational exuberance” decided to unveil his latest prediction last week: outlook dismal, stagflation ahead.

Let’s start with the new Fed chairman. Reading from his prepared script, Powell promised to “provide continuity in monetary policy,” which includes three small interest rate increases during the year, and a continued gradual sell-off of the mortgages, bonds, and other assets the Fed acquired in its attempt to prevent the Great Recession from becoming the Great Depression. Reading scripted remarks is one thing, answering unscripted questions is quite another.

In response to one question, Powell, truthfully but undoubtedly to his later regret, indicated that continuity means no changes—but only until later this month. Yes, three rate hikes is what the monetary policy committee decided at its December meeting. Then he added the phrase that rattled markets, “but since then.” Since then “incoming data suggests [sic] . . . strengthening in the economy . . . continuing strength in the labor market . . . continued strength around the globe, and we’ve seen fiscal policy becoming more stimulative.” So the members of the committee will be thinking things over when they meet later this month “and I wouldn’t want to prejudge that.” Translation: We very well might pencil in a fourth rate hike. Result: bond prices down, interest rates up, and an immediate 1.5 percent drop in shares.

Powell is smart and is unlikely to make such a mistake again. But he also is unlikely to master the studied ambiguity/obfuscation of the master of the art that Alan Greenspan practiced when he held the Fed chair for almost two decades. Freed of the constraints of that position, Greenspan is free to speak his mind in clear, precise English. Which he did last week on CNBC.

In the short-term, he said he expects the economy to do well in response to what some call the Trump tax reform and more discerning observers call the Trump tax cuts. But the long-term outlook is “rather dismal . . . the budget deficit . . . is downright scary.” We are headed for “stagflation,” with prices rising but the economy stagnant. “We are in a bond market bubble.” When that bubble bursts, bond prices will fall, causing interest rates to rise and share prices to come down. By some 15 percent to 20 percent, according to one former Fed governor, who notes that the central bank has no statutory mandate to maintain share prices until their decline threatens the stability of the financial system and the economy. In the jargon of the trade, there will be no Powell “put.” Sell, sell became the word on Wall Street.

So we have an optimistic Jay Powell in the chair, and a legendary predecessor predicting that current exuberance in the bond and stock markets will come to tears unless something is done to rein in the deficit. The identical panicked response to both optimism and pessimism proves that those who refuse to predict immediate market reactions to breaking news are right to sheath their fountain pens, at least until pressure from clients and editors to say something becomes irresistible.

In this case, both men have it right. As Powell told Congress, the economy is reasonably strong, the job market is “robust,” and that should support income growth and consumer spending. Business sentiment is “upbeat.” He might have added that last month consumer confidence rose to its highest level in 18 years, reflecting consumers’ satisfaction with their current situation and outlook. Inflation is picking up a bit and seems headed towards the Fed’s preferred 2 percent rate, but in the face of Jeff Bezos’s threat—“your margin is my opportunity”—many companies are likely to avoid attracting the attention of Amazon by raising prices markedly. Near-term outlook rosy.

Greenspan is looking longer term. There was a time, before Trump’s hostile takeover of the Republican party, when it could be counted on as the voice of fiscal sanity. Now that anchor on the national fisc has become a helium balloon with Republicans, some rueful, some not, falling all over themselves to be at the front of the queue of those praising the recent tax cuts that will increase the deficit by $1 trillion over the next ten years, even after counting treasury receipts from stepped-up economic growth. And some agreeing to spill even more red ink over the nation’s ledgers by paying a two-year, $131 billion bribe to Democrats who were demanding additional domestic spending in return for going along with a $165 billion increase for the military. These military-hawks-turned-inflation-doves are prepared to continue such bribery during the decade it will take to restore the military to its pre-Obama state of readiness. Long-term outlook dire.

The problem this creates for Powell is that he is taking the reins just when the politicians have gone to war with the Fed. The White House and its abettors on Capitol Hill are loosening fiscal policy to speed up the economy while Powell & Co.’s plan to tighten monetary policy will slow it down. One foot on the gas pedal, the other on the brake.

Gary Cohn, the highest-placed purveyor of economic advice to the president, says “We know how to deal with inflation.” Indeed we do. That would be by stomping harder on the brake—raising interest rates faster than the Fed now intends—and easing up on the gas pedal by lowering spending or raising taxes. That would slow the economy, but increase tweet production.

And would also make it certain that Powell, who was not promised a rose garden, will never get a friendly turn around the Rose Garden with its current proprietor.

Not only has the Republican party abandoned any semblance of fiscal responsibility, its putative leader has put paid to its support for free trade. Trump stunned many of his supporters by keeping his promise to impose tariffs wherever he believes American industry is being treated unfairly, as he defines the term. It seems there is nothing more unsettling than a politician who translates his campaign promises into policy.

All much ado about very little. An extra quarter-point increase in interest rates can hardly turn black ink to red on corporate income statements. And international trade is too small a part of the U.S. economy for a trade skirmish—the real war will be with China—to warrant the panicked reaction of investors.