Lessons from last century for today's policymakers

At a ‘Fed Listens’ event held where the US central bank’s policy-setting board meets, Federal Reserve Chair Jerome Powell in October described how the room with “26-foot (eight-metre) ceilings, a monumental marble fireplace and a 1,000-pound (450-kilogram) brass and glass chandelier” had “seen a lot of history since Franklin Roosevelt dedicated this building in 1937”.

That’s probably the most innocuous economic event linking 1937 and the 32nd president. The pairing is more renowned for the ‘depression within a depression’ Roosevelt triggered in his second term when he tightened monetary and fiscal policies after US production surpassed pre-Depression levels.

Under Roosevelt’s direction, the Fed boosted bank reserve requirements by 50% and the Treasury withheld gold inflows from the monetary base, to guard against inflation. Government spending was cut in a quest to eliminate the federal deficit within two years. The result was the third-worst recession of the 20th century. Real GDP dived 10% and industrial production plunged 32% while the jobless rate jumped to 20% as four million people lost their jobs.

Roosevelt’s premature tightening still haunts US policymakers. Avoiding 1937-style missteps was pertinent in 2016 when the economy was healthy enough for the Fed to tighten monetary policy and for the administration of Barack Obama to reduce budget deficits towards 2% of output from a post-crisis peak of 10% of GDP in 2009.

That the US expansion that began in 2009 has entered a record 11th year shows officials have avoided a 1937 rehash. To help ensure no repeat, the Fed this year resumed loosening monetary policy, while Washington’s budget deficit is widening. President Donald Trump’s tax cuts of 2017 have stretched the shortfall beyond 4% of output.

Prolonging an upturn with stimulus is an achievement but it comes with risks. Three leap out.

 One is that stimulus can delay adjustments an economy might need to thrive over the long term. Today’s US recovery is sluggish and it is at risk if imbalances metastasise. These distortions include record asset prices and government, household and business debt at worrying levels.

A second is the Fed is unable to respond in a meaningful, conventional way to threats. The central bank has cut the cash rate to between 1.5% and 1.75% and its balance sheet is still distended from three bursts of asset buying (or quantitative easing).

The third, flowing from a stranded Fed, is that policymakers might need to double down on fiscal solutions to extend the expansion. The risk with loosening fiscal policy is it might feed doubts about US government finances. Washington’s projected deficits, on top of almost continual shortfalls since 1970, are forecast to boost its debt to 95% of GDP by 2029, the highest ratio since just after World War II. At some point, the public and investors could lose confidence in Washington’s budgeting abilities.

Given the gloomier outlook, US policymakers will be under pressure to prolong an expansion that already contains imbalances. The question they might ask themselves as they view these distortions is whether extending the expansion might lead to an uglier downturn than what they might have evaded so far.

To be sure, any slump comes with social costs best avoided; policymakers had little choice politically but to stimulate the economy when they could. The US’s imbalances aren’t as large as those of the eurozone and Japan, where radical stimulus has largely failed to stir robust growth. It should be noted too, that rather than stimulus, micro-economic reforms that boost productivity would be a better way to raise long-term living standards. But policymakers almost always must do something and stimulus is handy like that.

Now conventional monetary policy is nearing its limits, authorities could be tested on how much fiscal stimulus they can inject without stoking distortions or triggering repercussions that trouble the economy. The longer the recovery, the greater the risk that a coming year might gain infamy for when policymakers realised that endless stimulus leads to a bigger downturn.

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Magellan was formed in 2006 by Hamish Douglass and Chris Mackay, two of Australia’s leading investment professionals. The company specialises in global equity and listed infrastructure assets.

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