Written exclusively for InTouch Capital Markets
21st December 2017
By Steven K. Beckner
The Federal Reserve is about to experience an almost unprecedented amount of change in leadership and composition heading into 2018, but all this change does not necessarily imply significant change in U.S. monetary policy — not at least until economic and financial conditions change significantly.
Of course, circumstances will change, as they always do, for better or worse. But even then, it’s doubtful whether the Fed will go in unpredictable new directions.
For now, it seems likely the U.S. economy is destined for stronger growth, lower unemployment and (eventually) more inflation to go with soaring asset prices. Massive tax cuts will present the new Fed team with challenges monetary policymakers have not faced in many years. But, presumably, it’s a good problem to have, provided it’s not mishandled.
If the Fed goofs, the next challenge could be confronting recession. That’s probably inevitable at some point, but it need not be accompanied by a financial crisis. Fortified with stronger capital and liquidity requirements and other safeguards, the banking system is better able to weather a market correction than in 2007-08, and neither the corporate nor the household sectors are over-leveraged.
So you might say it’s a fortuitous time for the Fed to be undergoing wholesale staffing changes.
Not only will the Fed soon have a new Chairman, it will be getting a new Vice Chairman and a new president of the Federal Reserve Bank of New York, who also serves as vice chairman of the Fed’s policymaking Federal Open Market Committee. If you’re not sufficiently confused, the Fed already has a new vice chairman for supervision in Randall Quarles.
We already know who will succeed Janet Yellen as chairman. It’s Fed Governor Jerome Powell, a former lawyer, Treasury official and investment banker. Seldom, if ever, did he differ from Yellen when it came to monetary policy (Regulatory policy was a different matter).
We’re still waiting to hear President Trump’s nominee to fill the departed Stanley Fischer’s large shoes in the vice chairmanship. Powell will presumably have a lot to say about who his vice chairman is. He will presumably want an economist with strong monetary grounding.
We also won’t know for a while who will take William Dudley’s place at the New York Fed when he steps down in July. That will also be a crucial hire. The New York Fed president has a perennial vote on the FOMC, is in charge of implementing FOMC policy decisions and is the main interface with the world’s leading financial institutions.
The Chairman, Vice Chairman and New York Fed (Yellen, Fischer and Dudley in recent years) form the U.S. central bank’s leadership triumvirate.
One of the empty seats on the Fed Board of Governors has been filled, assuming he is confirmed by the U.S. Senate, by Carnegie-Mellon economics professor Marvin Goodfriend, long-time director of research for the Richmond Fed and a member of the monetarist Shadow Open Market Committee. His nomination still leaves three Board vacancies for Trump to fill.
Based on what we know about Powell, it looks as if change will come with much continuity.
This is not to say there will be no monetary policy changes under Powell & Co. — just that policy is more likely to be dictated by conditions than by personnel.
Yellen bequeathed a gradual approach to normalization of interest rates and the balance sheet. Powell unflinchingly supported that strategy.
At his Nov. 28 confirmation hearing before the Senate Banking Committee, Powell left little doubt he basically reads from the same sheet music as his predecessor.
He said it was right for the Fed to remain “committed after the financial crisis to providing significant accommodation to the economy after it recovered.”
The FOMC waited until December 2015 to start raising the federal funds rate from near zero and waited until October 2017 to start shrinking the $4.5 trillion balance sheet built up by three rounds of large-scale asset purchases (“quantitative easing”).
“That patience served us well,” Powell told the Senators, but “now growth is strong and appears to have picked up,.. so it’s time for us to be normalizing interest rates.”
Foreshadowing the third funds rate hike of the year on Dec. 13 (the fifth since leaving the zero lower bound), Powell said “the case for raising rates at our next meeting is coming together … I think the conditions are supportive of doing that…”
Looking ahead, he said holding rates artificially low is “no longer appropriate. That’s why we’re raising rates on a gradual path… I expect that will continue.”
For Americans on fixed income investments who have been suffering from extremely low rates of return, Powell said, “help is on the way.”
Powell also made clear he’s committed to continuing the steady, gradually escalating shrinkage of the balance sheet until it reaches roughly half its post-crisis level in the next two to three years. Ultimately, he said, it will be “much smaller than the balance sheet today, but much higher than” before the crisis.
Powell had previously indicated the Fed should only diverge from that strategy and halt or reverse balance sheet reduction if there is “material deterioration” in the outlook. And he has indicated he favors staying with a “floor” system of operation, allowing relatively large levels of bank reserves with money market rates undergirded by payment of interest on reserves and, as needed, overnight reverse repurchase agreements, rather than return to the pre-crisis tactic of keeping reserves scarce and pegging the funds rate through open market operations within a “corridor system.”
In June, Powell said the floor system is “simple to operate and has provided good control over the federal funds rate.”
It has become such a cliche that Powell will merely continue Yellen’s policies that perhaps a caveat — at least a nuance — is in order.
A colleague suggests he may be more malleable: “Jay is certainly more of a centrist sort of guy than he was when he came in.. He sort of drifted toward the middle.” Yellen on the other hand, “was always balancing kind of being in the center versus wanting to take any opportunity she could to avoid raising rates, to pause or delay. I think Jay will be on the other side… He’ll be a centrist, but will be more determined to raise rates and a little less willing to pause.”
The gradual rate path was redefined by the FOMC at its December meeting.
Even though the 16 FOMC participants upgraded their GDP growth forecast for 2018 by four tenths of a percent to 2.5% and lowered their unemployment forecast by two tenths to 3.9%, they did not revise up their near-term funds rate projections.
Fed officials still foresee three rate hikes taking the funds rate to 2.1% in 2018 and see it rising to 2.7% in 2019. But they raised their projection for 2020 to 3.1% — three tenths above the 2.8% neutral rate, which had been revised down by two tenths in September.
Yellen told reporters she and her colleagues had “factored in the prospect of fiscal stimulus along lines being contemplated by Congress into their projections,” but said there was “considerable uncertainty about the impact” of tax cuts.
Explaining why upward GDP revisions and downward unemployment revisions had not been accompanied by a steeper funds rate path, Yellen said, “You might think, well, shouldn’t I see more? Well, okay, growth is a little stronger. The unemployment rate runs a little bit lower, that would perhaps push in the direction of slightly tighter monetary policy, but again, counterbalancing that is that inflation has run lower than we expect, and, you know, it could take a longer period of a very strong labor market in order to achieve the inflation objective.”
That reflects the predominant Fed view of things, and it’s not hard to imagine Powell saying the same.
The December Summary of Economic Projections shows a willingness to accept and accommodate faster growth and tighter labor markets. The FOMC showed little inclination to counter pending fiscal stimulus with offsetting monetary tightening moves. For now, they are content to stay on their gradual course.
In the majority’s view a combination of faster growth, lower unemployment and relatively modest rate hikes is made feasible by low inflation along with modest wages, coupled with doubts about how tight the labor market really is. As Yellen said, the labor market is “not overheating.”
At the same time, Powell and company don’t want to unduly attenuate rate normalization — to “pause” or wait for higher inflation before raising rates, as Minneapolis Fed President Neel Kashkari and Chicago Fed President Charles Evans wanted to do Dec. 13.
Powell would undoubtedly support the view that diminishing labor market slack and ever easier financial conditions justify at least three rate hikes next year. 2017 was the first year the FOMC has done as many rate hikes as projected, and 2018 could continue if not exceed the pattern.
Whether rate hikes under Powell stay on that path or become more or less gradual will depend on evolving economic and financial conditions.
There are those around the Federal Reserve system who would have preferred Yellen had been reappointed, but generally everyone approves of Powell’s selection. Insiders were pleased with his performance at his confirmation hearing.
The thoughtful but good-humored Powell is liked and respected among other Fed policymakers and staffers who have worked with him.
The fact Powell does not possess a PhD in economics does not greatly concern people at the Fed, knowing he’ll get ample advice from the Board staff. But, as one long-time associate observed, he will want and need to rely on more than just the staff. He’ll want to get independent opinions, lest he be dominated by them.
That’s why the selection of the vice chairman and the New York Fed president matter so much. Yellen was tight with both Fischer and Dudley. Presumably, Powell will want a similar situation.
Stanford University professor John Taylor, who was in the running for Fed chairman, is one possibility to fill the vice chairmanship. Taylor is known for his eponymous monetary policy rule, which has been subjected to much criticism but which Fischer nonetheless described as a “useful” guideline. His free market credentials would seem to make him a natural Trump nominee.
Others have been mentioned, including Mohamed Aly El-Erian, chief economic adviser at Allianz. But El-Arian’s former association with the Obama administration might hinder his nomination. He also has his critics. As one confided, “He’s just kind of a lot of hot air — a lot of superficial trend spotting. Not well-grounded. Every few months he sees a new paradigm.”
Who takes over the presidency of the New York Fed and the FOMC vice chairmanship also bears watching.
Dudley had been chief economist at Goldman Sachs before coming to the New York Fed to run the Open Market desk, then succeeding Timothy Geithner as president. Some are rooting for another economist to succeed Dudley.
“It’s really critical that one (either the Board vice chairman or the New York Fed President) be a really solid economist,” a Fed insider commented.
While it’s certainly important who succeeds Dudley, the New York Fed president has almost always been a loyal lieutenant of whoever is Chairman
That’s not to say the New York Fed chief is just a mind-numbed robot, serving no useful purpose but to march lockstep with whoever happens to be Chairman. Not only does the head of the premier Federal Reserve Bank provide valuable insight into financial markets and implement FOMC policy decisions; he can sometimes play a key role in policy communications.
The New York Fed president has been known to send important and timely signals to the markets. When I interviewed Dudley in February 2016, he strongly hinted the Fed would be in no hurry to raise interest rates a second time by saying a weakening global economy accompanied by further dollar appreciation could have “significant consequences” for the U.S. economy.
“We’re acknowledging that things have happened in financial markets and in the flow of the economic data that may be in the process of altering the outlook for growth and the risk to the outlook for growth going forward,” Dudley told me.
Any number of plausible, eminently qualified candidates can be postulated from within the Bank and from its Wall Street neighborhood. But the Bank’s board of directors is casting a very wide net under pressure to increase “diversity,” especially after the criticism the Richmond Fed took for selecting McKinsey & Co. executive Thomas Barkin, a white male, to succeed Jeffrey Lacker as its president.
A PhD economist like Dudley has not always run the New York Fed. His predecessor Geithner had been Under Secretary of Treasury for International Affairs, then director of Policy Development at the International Monetary Fund. Before Geithner, William McDonough had come from the commercial banking industry. Not since Gerald Corrigan has the job been held by a PhD economist.
But all have had intimate knowledge of financial markets and institutions, and it’s hard to believe the New York Fed would not appoint someone appropriate with whom Powell can work.
Personnel aside, it’s clear monetary policy could be influenced by fiscal policy in a way not seen since the 1980s — the last time major tax reform was enacted.
Uncertainty about the final shape of tax reform is over, but still uncertain is the impact on an economy whose growth has already accelerated to 3%-plus.
Critics either minimize the impact of tax cuts or warned they will force interest rates up so much that they trigger a recession.
Others see positive effects on both the demand and supply sides. The usually restrained Joint Committee on Taxation estimates a 0.8 percentage point boost to GDP growth.
The cut in personal tax rates, though not as dramatic as those for businesses, could boost aggregate demand and also induce more idle workers to return to the labor force.
The reduction in the corporate tax rate from 35% to 21%, along with generous expensing allowances and incentives to repatriate capital could spur more business investment, increase capital formation and in turn productivity and the economy’s growth potential, while also justifying bigger wage increases.
So while the tax cuts could accelerate growth and put pressure on resources, they could also enable the economy to grow faster without accelerating inflation.
The truth is no one really knows, but don’t underestimate the U.S. economy’s latent dynamism.
Fed officials, who had until recently been lowering their estimates of GDP potential and the longer run funds rate may have to reassess those assumptions.
A hopefully well-advised Powell will need to be flexible enough to adapt monetary policy accordingly. The FOMC “dot plot” has never been set in stone. Monetary policy has never been on “a preset course,” as Yellen has often said. That may be truer than ever in the year ahead.
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.