By Nick Timiraos 

The stock market's recent selloff crystallizes four important challenges facing the Federal Reserve's new chairman, Jerome Powell, who takes charge Monday.

Low inflation and steady job gains allowed his predecessor, Janet Yellen, to raise interest rates slowly, enabling the economy to heal and the markets to romp ahead. Mr. Powell takes over amid signs this blissful combination might no longer be possible.

Fed officials raised their benchmark short-term interest rate last year to a range between 1.25% and 1.5% and penciled in three quarter-percentage point increases this year. Whether Mr. Powell and his colleagues stick to this path largely depends on the four central questions that loom ahead.

First, what does the Fed do if the economy gets too hot? Telltales could include faster wage gains and further run-ups in asset values. If the market tumble continues, it could spook investors and turn into more serious turbulence.

The last two economic expansions ended with bursting asset bubbles that triggered recessions in 2001 and 2007.

Those recent examples are likely front of mind for Mr. Powell, a former private-equity executive who is also the first non-economist to lead the central bank in three decades. Mr. Powell is expected to provide continuity with the Yellen era, in part because he consistently voted to support her policy moves and never voiced public disagreement.

"He understands what cheap money can do in the marketplace," said Steven Blitz, chief U.S. economist at TS Lombard, a research firm. In 2006 and 2007, Fed officials were too slow to recognize bubbles by "narrowly viewing inflation as consumer prices only, and Powell won't do that," he said.

Despite the recent pullback, stocks are up around 3% this year after advancing 25% last year. Adjusted for inflation, the price-to-earnings ratio is nearing all-time highs seen during the 2000 tech-stock bubble.

Home prices, also adjusted for inflation, are back to levels last seen in 2004, when bubbles began inflating.

The Fed has strengthened bank regulation, but its tools to contain wider damage to the economy from bubbles haven't been tested.

Boston Fed President Eric Rosengren said in an interview last month he worries more investors are buying riskier assets across more markets to achieve higher returns. This poses a risk to financial stability that could require higher interest rates than now envisioned, he said.

Second, officials must decide how to respond to President Donald Trump's $1.5 trillion tax cut.

In the short run, giving businesses and consumers more money could spur demand for equipment, homes and other goods. If the tax cut encourages people to work more and businesses to invest more, it could raise the economy's long-term growth rate by increasing the number of workers and the goods and services they can produce.

Either outcome could lead to higher interest rates than now planned. If Fed officials conclude the tax cut is boosting demand without boosting the economy's potential -- for example, because inflation begins rising too much -- the Fed might boost borrowing costs more aggressively.

If it looks like the tax cut is increasing the economy's supply side by generating more investment, the Fed can tolerate faster growth. But higher potential economic growth would boost the so-called neutral federal-funds rate, a level compatible with consistent low U.S. unemployment and steady inflation. This would lead the Fed to raise interest rates higher than now planned.

A demand boost from the tax cut could drop unemployment to uncomfortably low levels. Economists at Goldman Sachs Group Inc. see the tax cuts reducing unemployment from its current 4.1% rate to 3.5% by the end of this year and 3.3% next year, a level not seen since the early 1950s.

Central bankers don't have a good record of being able to gradually cool down the economy when unemployment drops far below the level considered sustainable over the long run, which Fed officials currently estimate is around 4.6%.

Third, what does the Fed do if inflation moves too far above or below its 2% target?

Officials want inflation to rise to 2%, a level they view as consistent with a healthy economy, but not to shoot much higher.

Inflation has been subdued for the past half-decade, perplexing officials who had predicted bigger wage and price increases as the economy expanded.

Price drops last spring for a handful of items, such are wireless--phone plans, led to a string of soft inflation readings. Fed officials said they expected this would prove transitory, eventually leading to an inflation rebound.

Rising bond yields show investors have started to believe inflation is going to rise and the Fed will have to respond. Indeed, last week the Fed subtly tweaked its postmeeting statement saying "further" gradual rate increases would be needed. The addition of the word "further" showed slightly more conviction in Fed officials' expectation of better growth and more rate rises.

If inflation surges too much above 2%, Fed officials would want to raise interest rates to bring it down. But it is too soon for Fed officials to be sure price pressures will keep rising.

Inflation should climb during the first half of this year, when last year's weak readings drop out of annual comparisons. But housing costs, a large piece of the consumer price basket and a source of outsize gains in recent years, appear to be cooling.

Economists at Société Générale forecast inflation to reach 2.4% in the first part of this year, before the deceleration in housing costs drags it down to 1.6% in September. Any inflation softness would complicate plans to raise interest rates.

Finally, Mr. Powell faces a debate over how the Fed should plan for the next downturn, when officials are likely to have much less room to cut rates than they had in the past.

There are growing calls within the Fed for officials to rethink their 2% inflation target. The main reason: They expect to raise their benchmark interest rate to around 3% by 2020, a lower level than in the past.

In recent downturns, the Fed has cut rates by at least 4 percentage points to stimulate growth when recession hits, meaning policy makers may have less juice during the next downturn.

Agreeing to tolerate periods of inflation above 2% would allow the Fed to raise rates more than currently planned, creating more room to cut them if needed.

To be sure, this process is likely to play out over many months. And any changes would require Mr. Powell to explain the Fed's reasons to Congress, financial markets and the public.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

February 04, 2018 12:18 ET (17:18 GMT)

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