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Kevin Wersh has now been sworn in as the new Federal Reserve Chairman. Outgoing Chairman Jerome Powell has refused to leave the Fed Board of Governors, breaking the modern custom that Fed chairmen leave the board rather than remain as rival power centers.
The obvious danger: Powell would have enough board support to act as Fed shadow chair and force a series of rate hikes down Varsha’s throat.
Never mind that a single rate increase would be the worst reaction to an oil price shock. Never mind that Jay Powell’s two predecessors understood the difference between demand inflation and oil shocks.
When Iraq invaded Kuwait in 1990, Alan Greenspan understood that an oil shock could increase gross inflation and harm growth. His FOMC repeatedly cut the federal-funds rate as the economy weakened.
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When oil, foods, fertilizers and industrial metals all rose sharply in 2008 – due to rising emerging market demand, constrained supply, low spare capacity and speculative flows – Ben Bernanke’s Fed similarly cut the federal-funds rate in April. He then maintained stability in June and refused to launch a bearish rate-hike campaign at prices the Fed couldn’t drill, refine, mine, plant or ship away.
This is the emerging central error. The Fed cannot produce an additional barrel of oil. It cannot reopen shipping lanes. It cannot refine gasoline. It can’t reduce the cost of diesel by crushing mortgage demand in Ohio or by forcing a small manufacturer in Pennsylvania to make loans at punitive rates.
Now, a Fed rate hike in response to a supply shock would rein in demand and hit exactly where the economy is already weak. Housing will become more weak. Interest-sensitive manufacturing will suffer. Small business lending will be tightened. Just as energy prices eat away at real incomes, financial conditions will tighten. The dollar may strengthen, which may put pressure on exporters.
Memo to the Fed: Oil shock already works like a tax increase. It drains money from household budgets, increases transportation costs, squeezes margins and slows real activity. If the Fed piles another rate hike on top of that, that doesn’t solve the oil problem. It simply adds a credit shock to an energy shock.
Why do this when bond market watchdogs are already pursuing contractionary policy? A 30-year Treasury yield north of 5% and a ten-year Treasury yield north of 4.5% are not loose money. Mortgage rates, corporate borrowing costs and tenure-sensitive assets are already feeling the heat. In that season, the central bank does not need to prove its toughness or independence by firing another round into the hull of the ship.
Nor is April’s inflation report any reason for panic. Core PPI warmed slightly at 4.4% but core CPI was 2.8%. No numbers justify treating an energy-based commodity shock as a demand-side emergency.
The right question is whether the oil surge will spill over into fundamentals and create a second round of wage-price dynamics. We still have a long way to go before we know, and the Fed should not be in the business of playing the worst-case scenario.
Instead, the Fed’s job, as always, is to keep inflation expectations stable while preserving maximum employment. As long-term bond yields rise, the risk increasingly moves toward recession – as Greenspan and Bernanke understood long ago.
This is where the ghost of Powell as shadow chair raises its ugly head: The three governors appointed by Biden — Philip Jefferson, Michael Barr and Lisa Cook — remain in place. Powell and the Biden trio now already have a four-vote majority on the seven-member board. Quite bad.
If Trump appointee Christopher Waller proves to be a decisive turncoat, as he is indicating, it would destroy Powell’s shadow chair majority. Varsh will have the title. Powell will control the response function.
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And the regional Fed chairmen in Cleveland, Minneapolis and Dallas — Beth Hammack, Neel Kashkari and Laurie Logan — are already forming a chorus line for a possible aggressive pivot.
It is by this shadow chair mathematics that Kevin Warsh – and the US economy – may be trapped. If Powell, his Biden-era allies, and regional hawks force a rate-hike campaign amid the oil shock, they will not defend the Fed’s credibility or prove its independence. They would add a credit shock to the energy shock – and only prove negligence. The bill would come not to the Eccles Building, but to factories, homes, small businesses, and export markets across America.
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