As Jerome Powell, President Trump's nominee to become Federal Reserve Chairman, prepares for his Senate confirmation, he should be awed by some of the challenges facing his institution. This has not been an easy decade for the Fed. True, the institution includes some extraordinary talent and remains one of the few islands of civility in the Washington partisan cesspool. But for central bankers, the world has changed. In coming years, Mr. Powell and the rest of the Fed need to be more realistic about the institution's loss of power vis-a-vis the financial markets. They cannot be the generals fighting the last war.
In the run-up to his nomination, Mr. Powell was described as the "status quo" choice. On the surface, preserving the status quo would seem to make sense. The economy is growing. Equity markets are at all-time highs. Labor markets have tightened. For some reason, inflation remains dormant. There is a calmness in the air. Both the markets and the economy seem to be in an unusual sweet spot.
But a number of perplexing things are also going on in the economy. This is no time for status quo thinking, no matter how calm financial markets seem. Remember, the stock market crash of 1987 came at a time when the economy's fundamentals seemed fine. Stock market exuberance fed on itself until... boom!
What's needed now is more critical forward thinking about the many things that could go wrong. Mr. Powell is taking over at a time when the world's public and private debt is approaching 300 percent of GDP. Central bank balance sheets are a horror show and the Chinese economy remains a mystery. In the United States, bloated corporate and "junk" debt markets remain vulnerable to a sudden shrinking of liquidity. So do emerging market debt markets. If this happens in today's interconnected financial world, other markets will also be at risk. This includes today's robust equity markets. Mr. Powell shouldn't forget: Since Harry Truman was president, nine out of the last ten economic dips happened under Republican administrations.
Today's soaring asset prices have become the U.S. economy's powerful engine, but as financial market strategist Mohamed El-Erian puts it: "We are close to exhausting the asset channel as the principal vehicle for promoting growth." The problem is not merely low volatility and high asset prices, he argues. Traders have developed almost an addiction to buying equities at every dip. Why? They believe central banks have pretty...