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”:
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