President Trump has an almost unprecedented opportunity to reshape the key personnel and legal basis of the Federal Reserve in the next 12 months, essentially rebuilding the most important economic organisation in the world in his own image, if he so chooses.
The President may be able to appoint five or even six members to the seven-person Board of Governors within 12 months, including the Chair, Vice Chair for monetary policy, and a new Vice Chair for banking supervision. He may also be able to sign into law a bill that alters aspects of the Fed’s operating procedures and accountability to Congress, based on a bill passed in 2015 by the House of Representatives.
Not surprisingly, investors are beginning to eye these changes with some trepidation.
Some observers fear that the President will fill the Fed with his cronies, ready to monetise the budget deficit if that should prove politically convenient. Others fear the opposite, believing that the new appointments will result in monetary policy being handed over to a policy rule (like the Taylor Rule) that will lead to much higher interest rates in the relatively near future. Still others think that the most important outcome will be a deregulation of the banking system that results in much easier credit availability, with increased dangers of asset bubbles and economic overheating.
It is not difficult to see how this process could work out very badly indeed. But, at present, I am optimistic that a modicum of sense will prevail.
During the election campaign, Trump was fairly consistent in calling for a Republican to replace Janet Yellen as Chair in February 2018, and for bank credit to be made more readily available to corporate America, especially to small companies. On the setting of interest rates, he has been inconsistent, and on rules-based monetary policy he has been largely silent. Meanwhile, Republicans in Congress seem focused on deregulation of the banking sector, with the partial removal of Dodd Frank, and a rules-based monetary policy mandate, with audits of the Fed by the GAO.
Fortunately, there does not seem to be any Republican support for using the Fed balance sheet to support inflationary financing of the fiscal deficit. Although that might come later, it will be hard to impose on the Fed once the appointments and institutional changes have been implemented in the next 12 months. After that, the new regime will be relatively free to operate under the new arrangements. A lurch towards inflationary populism is therefore not high on the list of worries at present.
The first test for the administration will probably be the nomination of the new Vice Chair for Supervision, a post left unfilled by President Obama, though the functions have been undertaken by the now departing Daniel Tarullo. It has been reported that Gary Cohn and Treasury Secretary Steven Mnuchin have been actively engaged in picking the nominee, which is very reassuring since they are likely to select an impressive professional who is fit to hold the most important regulatory post in America.
David Nason, identified as the front runner, certainly fits that bill. He has been strongly supported by Hank Paulson, his former boss at Treasury, and that support might influence Cohn and Mnuchin, both of whom, like Paulson, are Goldman Sachs alumni. The nomination of someone like Nason would calm concerns about the entire process.
Donald Trump has also been talking about giving the job to John Allison, a libertarian who admires the gold standard and doubts whether the Fed should even be setting interest rates. He has strong academic and business credentials, with coherent views about the capital requirements and regulation of the banks, but the markets would worry about the unpredictable consequences his appointment might have for monetary policy.
Although an important litmus test, the appointment of the Vice Chair on supervision pales into insignificance compared to the probable decision to replace Janet Yellen and Stanley Fischer in the two top slots next year. These appointments are not yet on the political agenda but the markets are already thinking about what they may portend for monetary policy after 2017. After all, unless reconfirmed, Yellen and Fischer will soon be viewed as lame ducks.
The administration can turn to a lengthy list of respected, mainstream macro-economists with broad affiliation to the Republicans: John Taylor, Greg Mankiw, Glen Hubbard and many others. There is another list of former Fed officials who would fit the bill, including Kevin Warsh and Richard Fisher. Then there is a very long list of business people or bankers that might be considered appropriate, some of whom could unfortunately be portrayed as Trump “cronies”. Finally, there are some “Austrian” economists, a school that has apparently influenced Vice President Pence.
An “Austrian” candidate would certainly alarm the markets. Assuming that is avoided, investors will be interested in a couple of issues.
Where does the new leadership sit on the divide between economist and non economist? The last four Fed Chairs have all been clearly on the economist side of the line, and because they have all bought into the Fed’s economic orthodoxy, their actions have been considered somewhat predictable by the markets. A business person or banker might be less predictable, at least initially, and more prone to shake up the Fed’s orthodoxies, for good or ill.
The second question will be whether the new team is supportive of rule-based monetary policy, with GAO audits. In recent years, the House of Representatives has tried on several occasions to bring forward legislation that would require the FOMC to establish an appropriate rule for setting interest rates and then explain to Congress why it had deviated from the rule in any future decisions. This would clearly shift the bias of policy making somewhat away from discretion, especially if a “rules guru” like John Taylor, or one of his academic supporters (listed here), becomes Chair.
The possibility of Congress forcibly imposing a rules-based regime is being taken increasingly seriously inside the present Board, which has followed the Fed tradition in strongly preferring discretion to the rigidity of formal algorithms, even if they are selected by the Fed itself.
Janet Yellen, in her Congressional testimony last week, was unusually explicit about the adverse consequences, as she saw them, of adopting the Taylor Rule. She said this would require interest rates to rise to 3.5-4.0 per cent, leading to lower growth and higher unemployment.
Stanley Fischer has also weighed in, suggesting that the Taylor Rule would have resulted in a premature tightening in monetary policy after 2011 (see Appendix below). But a new law similar to the bill passed by the House in 2015 would allow them plenty of scope to deviate from the rule if they so choose.
How will the Fed emerge from these potential shocks? The organisation has an extraordinarily strong and much admired culture, which will be hard for Trump to shake, even if he wanted to. All his nominations will be reviewed internally by Cohn and Mnuchin, and externally by the Senate.
My guess is that the institution will survive largely unscathed, albeit with onerous regulation of bank credit, and some increased role for specified monetary rules, with formal reporting on these rules to Congress. Compared to the present regime, this may lead to higher, rather than lower, interest rates.
The current Fed Board will (rightly) try to minimise any restriction on their discretion and independence. But in practice the likely new framework would not represent much of a threat to the sensible conduct of monetary policy in President Trump’s term.
Appendix: Recent Fed Comments on the Taylor Rule
In her latest speech, Janet Yellen pointed out that the Taylor Rule would, in its basic form, suggest that short rates should already be around 3.5-4.0 per cent. This is about 300 basis points higher than the present level of rates, and much higher than the rates seen as appropriate in the next 3 years by every single member of the current FOMC. This graph is taken from her speech, which also suggests that other versions of the “rule” would indicate a lower path for rates than the one shown here:
In his most recent speech, Stanley Fischer (see Tim Duy) showed a graph that had been submitted to the FOMC meeting in April 2011. In August 2011, the committee decided to ease policy by extending its promise that short rates would be held at zero at least until mid 2013, compared to a previous formulation that simply said “for an extended period”. This decision to ease monetary policy was taken despite Taylor Rule predictions that would have required a much earlier rise in short rates. Fischer hints that the more dovish judgment made by the committee was more appropriate than the more hawkish implications of the Taylor Rule. Here is the graph from the Fed staff’s April 2011 “Tealbook”:
This post originally appeared on Financial Times