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Jerome Powell can roil markets now with just a word

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By Mohamed A. El-Erian


Judging from the initial market reaction to remarks by Federal Reserve Chair Jerome Powell on Thursday, he would have been well advised to follow Aaron Burr’s advice to Alexander Hamilton in the hit musical “Hamilton”: “Talk less, smile more.” This is not because he said anything inherently wrong. He didn’t. Rather, it is because whatever he had to say had little chance of resonating well in markets given where they have been and where they wish to go.

Few economists or policy makers could take issue with what Powell said at a Wall Street Journal webinar. He was right to point to the rising likelihood of a pickup in inflation, which, based on technical factors and current economic conditions, is more likely to be a one-off phenomenon than the start of a serious inflationary process. Of course, the recent volatility in U.S. Treasuries in what is regarded as the most liquid financial market has caught his attention. And it should come as no surprise that the Fed will remain patient, maintaining its current policy approach until it believes that labor market slack is well on the way to being eliminated.

Yet despite this, his words were the main driver of a sharp steepening in the yield curve between the two-year note and both the 10-year note and 30-year bond as well as a 900-point trading range for the Dow Jones Industrial Average, which ended down 346 points, or 1.1%. The Nasdaq lost 2.1%, and the S&P 500 Index finished down 1.3%.

Reconciling these two realities — warranted economic comments and significant market volatility — provides important insights into both the mindset of markets and the intensifying communication challenge for the Fed.

Long driven — and now highly dependent — on central bank liquidity injections, markets wanted Powell to strike a tricky balance between two things: On the one hand, continued reassurance that the liquidity spigot will remain not just fully open but also supplemented by new dovish measures such as a revival of Operation Twist; and, on the other, an affirmation that earlier and coming large amounts of fiscal and monetary stimulus will not overheat the U.S. economy, which would inflict both immediate and longer-term damage.

This is a clear example of what I have detailed in earlier columns as an increasingly tight corner policywise for central banks that confronts them with an ever more uncomfortable lose-lose situation. This is likely to continue as the U.S. economic recovery quickens, the bond market looks to price in the prospects of both higher real growth and inflation, and the Fed finds itself torn: Should it allow genuine fixed-income repricing that risks destabilizing risk assets that have been driven excessively by actual and anticipated liquidity injections, or should it intervene further in markets and risk additional distortions and damage both to efficient market functioning and its own policy credibility?

The answer to this policy dilemma is to accelerate structural reforms and fiscal measures aimed at enhancing high, durable, inclusive and sustainable growth that would help validate existing elevated prices for many risk assets. Pending this, the Fed would be well advised to the extent possible to follow Burr’s advice to Hamilton. Any other action risks volatility that involves unsettling pockets of illiquidity in the most liquid markets of all.

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