Beckner: Don’t Discount Yellen As Potential Nominee for Fed Chairmanship

Written exclusively for InTouch Capital Markets

17th October 2017

By Steven K. Beckner

President Trump’s announcement of the next Federal Reserve chairman could come almost any time.

He’ll likely choose from a short list that includes Jerome Powell, John Taylor, Kevin Warsh and, yes, Janet Yellen. Other selections could be imagined, but the next Fed chief is likely to come from those four, all of whom have met with Trump.

Amidst the swirl of speculation about who Trump will nominate to succeed Yellen when her term expires in February, too little attention has been paid to the possibility he could re-nominate Yellen.

This is a different kind of President, who prides himself on doing the unexpected. In this case the unexpected, from the perspective of his political base, might be reappointing Yellen. But far from being capricious, that move would make sense. Reappointing her, while dismaying supporters, would:

– maintain monetary policy continuity

– reassure financial markets at a potentially vulnerable juncture

– sound a much-needed note of bipartisanship

It’s not that hard to imagine. True, Trump had harsh things to say about Yellen during his campaign. He accused her of “politically” holding down interest rates and vowed to replace her. But since his inauguration, Trump has dialed it back, saying he has been impressed by Yellen and is considering reappointing her.

It’s happened that way before.

I think back to 1983. After Ronald Reagan defeated Jimmy Carter in 1980 and launched a set of tax and other policies to rescue the economy from stagflation, speculation was rife that he would not re-nominate Paul

Volcker, Carter’s appointee to the Chairmanship. Many Republicans were furious at Volcker’s war against inflation, which was seen thwarting Reagan’s pro-growth agenda. But I predicted then that Reagan would reappoint Volcker, and he did. Later, of course, Reagan declined to offer Volcker a third term and replaced him with Alan Greenspan.

It wasn’t the last time a Fed chief was reappointed by a president of the opposite party. Greenspan, after first being appointed by Reagan in 1987 and reappointed by President George H. W. Bush (who later blamed him for not winning a second term) was reappointed by Bill Clinton. Ben Bernanke, after initially being appointed by President George W. Bush, was given a second term by Barack Obama. When Bernanke’s second term ended February 1, 2014, he was succeeded by Yellen.

Will Trump continue this bipartisan pattern? We’ll see soon enough.

If Yellen is not reappointed she would ignominiously be the first chairman since the Great Depression not to win a second term.

Although she has had some health scares, Yellen has given no indication she doesn’t want the job for another four years. She’s been mum, saying only she intends to serve out her current term, but it’s hard to imagine she wouldn’t accept a second term.

If Yellen is not tapped and goes off into retirement, the number of probable candidates is limited. Topping the list in my estimation is renowned economist John Taylor.

Taylor was passed over the last time a Republican president had a chance to nominate a Fed chairman in favor of Bernanke, but that doesn’t mean he’ll be passed over again. Though older now at 70, he’s still intellectually vibrant and active at Stanford University’s Hoover Institution, where he has written compellingly about monetary policy before, during and after the financial crisis.

Taylor’s views are more congenial, in many ways, to the Trump administration. Not only has he been a strong Fed critic, he’s a thoroughgoing free market advocate.

In his book First Principles, Taylor ripped the Bernanke Fed for how it handled the financial crisis and for its efforts to help the economy recover from the ensuing recession.

He complained the Bernanke Fed followed a discretionary path, unconstrained by any systematic or rule-based strategy.

Taylor contends Bernanke goofed in responding to the bursting of the housing bubble. The Fed should never have bailed out Bear-Stearns in March 2008, he argues, but having done so it set up expectations that other investment banks would get the same treatment — hopes dashed when the Fed let Lehman Brothers go under six months later.

“The Fed’s broad justification for the bailout in the case of Bear-Stearns led many to believe that the Fed would do the same thing with any similar institution,” he writes. But when Lehman was on the ropes, the Fed “surprised everyone and cut off access to its funds, refusing to bail out Lehman’s creditors.”

“The next day, it reversed course, reopening its access to rescue the creditors of AIG,” Taylor recalled. “Then it turned off access” as Congress hurriedly enacted the Troubled Asset Relief Program (TARP).

Taylor charges “the Fed’s on-again/off-again bailout measures were thus an integral part of a generally unpredictable and confusing government response to the crisis, which, in my view, led to panic.”

Nor did Taylor have much use for the “quantitative easing” the Fed undertook after the panic precipitated recession. Contrary to Fed claims, he says mortgage backed securities buying “had at best a small effect on mortgage rates.” He warned the resulting explosion of bank reserves “creates risks to the financial system and the economy. If it is not reduced, then the bank money will eventually pour out into the economy and cause a rise in inflation.”

Bernanke is fond of contending a “global savings glut” caused interest rates to be low worldwide and that the Fed’s low official rates had little to do with the housing boom/bust. But Taylor documents policy deliberations showing foreign central banks set their rates in line with Fed rates.

Taylor also criticized one-time boss Greenspan for “deviat(ing) in 2003-05 from the predictable rules-based policy that worked well in the 1980s and 1990s.” But he thinks Bernanke was far worse.

After Bernanke replaced Greenspan in 2006, “we saw monetary activism as it never had been seen before in the United States,” he writes. “Bernanke used the Fed’s resources in a highly discretionary way to bail out the creditors of financial firms. He coordinated with the administration and the Treasury to a degree that made William McChesney Martin look like a piker as he coordinated with the Johnson administration in the late 1960s….”

Notwithstanding such critiques, Taylor is highly respected in monetary circles. His eponymous Taylor Rule in its various iterations is widely used — not as a hard policy rule but as a guide or reference point, not just by the Fed but central banks around the world. The Rule, first unveiled in 1993, directs the central bank to adjust short-term interest rates when inflation and unemployment deviate from specified norms.

A perennial presenter at the Fed’s prestigious annual Jackson Hole symposium, Taylor has received high praise from Yellen. She has credited him with having “documented that FOMC policy changes since the mid-1980s had fairly reliably followed a simple rule based on inflation and output.”

In May, recently retired Vice Chairman Stanley Fischer said Taylor’s work “was a catalyst in changing the focus toward rules for the short-term interest rate” and “helped shift the terms of the discussion in favor of rules for the instrument that central banks prefer to use.”

Fischer said Taylor “highlighted the practical relevance of monetary policy rules … The research literature on monetary policy rules has experienced a major revival since Taylor’s seminal paper and has concentrated on rules for the short-term interest rate.”

At FOMC meetings, Fischer said the Taylor rule is “one benchmark that we regularly consult.”

Fischer and Yellen would not go so far as Taylor in actually hitching rate-setting to his Rule. As recently as last Friday, he has supported proposed legislation to do just that.

But one suspects even Taylor would become more discretionary as Chairman. He would likely apply his rule flexibly.

Though never a Fed policymaker he’s no stranger to policymaking. He served on the President’s Council of Economic Advisors during three administrations and was Under Secretary of the Treasury for International Affairs during George W. Bush’s tenure. He was a top economic advisor to 2012 Republican presidential nominee Mitt Romney.

At a Hoover Institution conference in May, Taylor argued the Fed should get back to pre-crisis reserve levels of about $14 billion and operate monetary policy through traditional open market operations within a “corridor” system, which would obviate the need to use interest on excess reserves or other tools to maintain a floor under the funds rate.

Taylor told the conference policy “should be predictable and strategic” and said “after normalization the interest rate should again be determined by market forces.” Let supply and demand for reserves determine interest rates.

Taylor warned that “as a long-term policy, a disconnect between the short-term interest rate and the supply of reserves creates problems.” In his view, the kind of policies the Fed has used since the crisis, notably MBS purchases, opened the door to the Fed being a “multipurpose institution.” Allocating credit and paying huge amounts of interest to large banks, including foreign ones, threatens Fed independence, he said.

Taylor gave a vision of a potential economic revitalization under Trump. Recalling that Reagan had combined tax cuts, deregulation and anti-inflationary monetary policy to produce an upsurge in GDP growth and job creation, he suggested that Trump could do much the same.

But a Taylor nomination may not be in the cards.

Another potential nominee, regarded as a lesser light, is Taylor’s much younger Hoover compatriot Kevin Warsh.

Husband of an heir to the Este Lauder perfume fortune, the 47-year-old Warsh has made his own mark as on Wall Street and in the policy world, though his training is in the law, not economics.

After working for Morgan Stanley for seven years, becoming executive director, he served as George W. Bush’s Special Assistant to the President for Economic Policy and Executive Secretary of his National Economic Council. That led to a seat on the Fed Board of Governors.

As a Governor from 2006-2011, Warsh was intimately involved in anti-crisis strategizing, bringing to bear his financial market experience.

Transcripts of the Fed’s rate-setting Federal Open Market Committee reveal his market-orientation. At the Dec. 15-16, 2009 meeting, he prefaced comments by saying, “Let me spend most of my time on financial markets, with just a few words on the real economy.”

Since leaving the Fed, he has been an outspoken critic who served earlier this year on Trump’s business advisory council.

Speaking at the Hoover conference, non-economist Warsh virtually lambasted the Yellen approach.

“We should not encourage policymakers to fiddle with the natural rate of employment (NAIRU) to rationalize the near-term conduct of monetary policy,” he said. “We should not accept the Fed’s newfound conviction that a very low neutral equilibrium real short-term interest rate (r*) is a fixed feature of future monetary policy. We should resist the pseudo-scientific precision being assigned to the Fed’s preferred measure of inflation, and we should not consider it a good arbiter of the output gap or good proxy for financial stability.”

Warsh urged “a fundamental rethinking of the Fed’s strategy, tools, governance and communications.”

Alluding to self-congratulatory official remarks about the Fed’s anti-crisis measures, he said “there is no holiday from history. Policymakers should not squander the grace period on a victory lap.”

Warsh blasted “the false choice between unfettered discretion and a mechanical rule… If we (the Fed) don’t have a strategy, how can we expect the rest of the world to know what we’re doing.” And so forth.

It is not clear where Warsh would land on the “hawk” “dove” spectrum, but he did say the FOMC “shouldn’t dwell on changes of one tenth of a percent” on inflation. He said it should “focus on the productivity puzzle” and its role in determining the economy’s growth potential and the neutral interest rate. “If we don’t have that right, we don’t have r* right….”

Though not a PhD economist, Warsh has clearly learned Fedspeak. But is he ready for prime time?  Not in the opinion of one former senior official, who confided that Warsh “doesn’t know what he’s talking about.”

Another lawyer with no economic credentials but plenty of financial market and policy experience, as well as bipartisan appeal, is sitting Governor Jerome Powell.

Powell, 64, served in the first Bush administration’s Treasury Department and had a long career at the Carlyle Group, a private equity firm before being appointed by Obama in 2012.

As a governor, Powell has taken the lead on financial market and payments issues. As chairman of a Financial Stability Board subcommittee, he spearheaded reform of the London Interbank Offering Rate (LIBOR).

As a monetary policymaker, Powell has seldom diverged from the FOMC consensus over the past five years. So it’s not clear what new direction, if any, Powell might take the Fed if appointed. Based on his track record of supporting the Chairman on policy, it might well be more of the same.

But Powell might be a safe, don’t-rock-the-boat choice for Senate Republicans and Democrats charged with confirming the nomination.

Other potential nominees have been mentioned. Not long ago, it was thought Trump’s senior economic adviser Gary Cohn had the inside track, but after the former Goldman Sachs executive erupted over Trump’s handling of the Charlottesville, Virginia riot, his star has slipped.

Other rumored dark horse candidates include Columbia University professor Glenn Hubbard. A dependable conservative economist, he was considered a prime candidate to succeed Bernanke had Romney defeated Obama, but there is little indication he’s in the running now.

Then there is gold bug John Allison, former BB&T CEO, who has urged that the Fed be abolished.

Realistically, Trump is apt to select from the first four.

If Trump decides to replace Yellen, there will be disappointment at the Fed and on Wall Street, but old central bank hands aren’t too worried.

The choice is important, of course, but perhaps not as important as you might think. Though primus inter pares on the Board and the FOMC, the chairman is still just one vote. Policy decisions are made by Committee consensus — more than ever in recent years. Gone are the days when an Arthur Burns could pretty much have his way.

Then too, the Fed is constrained by a statutory “dual mandate” of “maximum employment” and “price stability,” the latter part of which has been defined as a “symmetrical” 2% target.

The Fed staff, whose tenure extends beyond that of political appointees, has a great deal of input in and sway over policy. Fed governors and chairmen come and go, but key advisors stay on and on, accreting considerable influence. And don’t forget market constraints on Fed behavior. The Fed cannot simply dictate rate levels.

So there is a certain institutional continuity, not to say inertia, no Chairman is likely to change much.

For many of the same reasons, it seems doubtful that, even after filling numerous spots on the Board of Governors, Trump would be able to exert as much control over policy at the proudly independent central bank as some fear.

The Fed may not always make the right decisions, but they’re not usually made for political reasons.

Prior article by Steven Beckner for InTouch Capital Markets:  St. Louis Fed Chief Bullard Gaining Adherents For Low Rate Viewpoint

Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve.  Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.