Powell Should Pull Up on the Stick and Put Rate Hikes on Hold through the Summer

The Fed faces the tough challenge of engineering a soft landing for the economy.

The recent strong jobs report notwithstanding, manufacturing activity and bank business lending are slowing. Managing the situation is made terribly more difficult by the secular decline of Europe and China's recent woes, slowing economic activity abroad, the government shutdown and trade war with China, and structural changes that alter historical relationships between monetary policy and interest rates and employment and inflation.

The nearly 3% growth accomplished in 2018 was no accident of nature. The 2018 tax cuts and February 2018 budget deal that lifted federal appropriations caps through the current fiscal year boosted consumer and government spending.

Lower corporate taxes permitted businesses to invest in labor-saving robots, artificial intelligence, and workforce training, and deregulation slashed private-sector compliance costs. All boosted labor productivity growth.

More demand, more supply, and the economy zoomed ahead.

In 2019, consumers are getting an additional lift from lower gas prices but the boost from personal tax cuts and higher government spending have largely run their course. And the slowdown in business bank borrowing likely indicates investments in machines, software, and skills are slowing too.

Brexit and Angela Merkel's imminent departure, the yellow-vest riots in France, and a populist government in Italy were nominally instigated by unchecked immigration, higher taxes on gasoline, and a left-right coalition agreement to spend more than the European Union's national debt limits permit.

In reality, the onerous regulations imposed by the EU bureaucracy and mercantilist policies in Germany that impose perennial trade deficits and austerity elsewhere are pulling the EU apart.

The bottom line is Europe can't grow - and it's America's most important export market.

China has run the string on credit-driven growth, and Republicans and Democrats alike are tired of Beijing's protectionism imposing a whopping $365 billion trade imbalance and exporting unemployment and social problems here.

The economy should recoup the lost spending by federal employees now that the shutdown is over, but the trade talks with China may accomplish only a temporary reprieve on the trade deficit. Past experience indicates trade deals with China do not result in lasting behavioral changes, and renewed tensions lie ahead.

A decade of low-interest rates boosted real estate and stock values in the United States and permitted struggling corporations and foreign governments to avoid reforms that would make them competitive and less corrupt. Now just about anything the Fed does has feedback effects on asset prices, corporate and foreign government finances, and ultimately U.S. exports and growth.

Finally, tools the Fed uses to navigate are broken. The Phillips curve, which charts the tradeoff between inflation and unemployment, is flashing red but the hard economic data say otherwise. Even with unemployment at 3.9%, wage increases of 3.2% pose few inflationary pressures with stronger productivity growth to pay for those.

The yield curve-the difference between the short- and long-term interest rates on Treasuries- has been flattening. Historically, that has proven a pretty good indicator of a recession in the next year or so. Theoretically, it is supposed to indicate businesses that buy equipment and hire don't believe that prospective sales growth justifies borrowing long-term to finance expansion.

The problem is that, since the 2000s, U.S. long rates have been suppressed by foreign investors. Europeans stuck in a lethargic economy, and Latin Americans and Asians fearful that their corrupt governments will ignite inflation to solve their debt problems, have been buying up U.S. real estate and long bonds.

Similarly, the dollar has increasingly become the preferred currency for all global trade, further increasing the demand for U.S. bonds.

Those unhinge the relationships between business expectations and interest rates. For example, the yield curve has been sending warning signals since late 2017 but the economy sped up last year instead of slowing.

Lacking the Phillips curve and yield curve as tools, Fed Chairman Jerome Powell is flying without an altimeter and air-speed indicator. Not being an economist, he hasn't been to pilot school either.

The best thing. Powell can do for now is pull back on the stick and announce he is not planning any more interest-rate increases until at least this summer.