Fed: The Chair

Published on October 20, 2017

Federal Reserve Chair Janet Yellen’s relatively brief 30-minute meeting yesterday with President Trump marked the last of the President’s Apprentice-style parade of the final five candidates (we almost said contestants) to head the Federal Reserve for a four year term beginning next February.

*** President Trump himself has apparently confirmed that a John Taylor-Jerome Powell Chair and Vice Chair twin nomination is under serious consideration, a scenario we highlighted last week (see SGH 10/13/17, “Fed: A Taylor-Powell Leadership Era”). We understand the White House has been weighing the broader mix of appointments to the Board of Governors, so we still think a Taylor Chair with Powell and Randal Quarles as the two Vice Chairs could become the new triumvirate of the next generation of Fed leadership. ***

*** In any case, our sense remains that the President’s selection of his nominee to lead the Fed after Chair Yellen’s term ends on February 3 has narrowed down to Powell and Taylor. We, however, do not rule out a surprise reappointment of Chair Yellen, in defiance of Republicans on Capitol Hill and indeed, most of his advisors. We understand the President wants one last meeting with his advisors to pitch their recommendations before he decides. An announcement could come as soon as early next week or at the end of next week just before the President is off to Asia. ***

*** Whoever the Fed Chair is next year, we doubt there is likely to be a significantly different rate path in 2018 than the already hawkish projections mapped out by the Yellen-led Federal Open Market Committee, which markets have consistently underpriced and continue to do so even after the latest sell-off. But what will be different next year is a new Chair needing to establish credibility with the markets, which will invariably be testing him on the first data or policy surprise amid uncertain inflation dynamics and a potentially significant fiscal policy boost. A Chair other than Yellen, in other words, could translate into higher market volatility. ***

An Already Hawkish Rate Path

When weighing the likely consequences of the potential changes in the Fed leadership, it is worth noting the Fed’s base case path is already hawkish relative to the market pricing, so it is hard to imagine it becoming more hawkish under a different Chair.

At minimum, it could be said the announcement of a presumably more hawkish Chair would jolt the market pricing up to the Fed’s current projections rather than as the rates policy, and data, unfold through next year.

But for now, under the current assumptions reflected in the FOMC’s September median rate dot plot, the highly likely rate hike at the mid-December meeting is set to be followed by at least two rate hikes, probably by summer, in order to lift to the policy rate up to a presumed 2% neutral rate; a third rate hike in 2018 is more likely than not, especially if the Republican tax cuts ambitions are realized that would be boosting aggregate demand in an economy already operating near full employment.

In other words, the base case rate path next year under the presumably two most dovish among the list of Fed chairs  — Chair Yellen herself and Powell, due to his proximity to Yellen —is already more hawkish than the current rate path being priced by the market.

More to the point, none of the presumably more “hawkish” candidates — Taylor, former Fed Governor Kevin Warsh, or National Economic Council Chairman Gary Cohn — are likely to drive the FOMC to an even more hawkish rate path in 2018.

Indeed, for the most part, a change in the Chair and the filling of the remaining Board seats with Trump appointments is more of a 2019 than 2018 story. And we would still question whether there would be all that dramatic change in the Fed’s reaction function to the data‎ next year and how it might alter the Fed’s projections. That is certain to be the case through the first half of next year.

Consensus and Credibility

Perhaps more importantly, as important as the Chair leadership obviously is, Fed rate policy is a Committee decision, and it takes time for an untested Chair to build the critical credibility needed to work with the senior policy staff and to shape a policy consensus among a solid majority of the FOMC voters comprising both the politically appointed Governors and the five District Presidents.

Too many dissents early on would undermine the sense of the new Chair’s leadership skills and sway over policy, both internally and in the perceptions of the market that is always hypersensitive for the slightest whiff of change or faltering in the Fed’s reaction function. That could introduce an element of uncertainty and market volatility that could prove very difficult to contain.

An incoming Chair just doesn’t have the power to dictate policy decisions, and if he did try to force a rapid change in direction, he is more likely than not to be outvoted on the FOMC, which would be fatal to his term. Credibility is everything to an incoming Chair, the one essential, defining mark of the Chair’s power and influence.

That perhaps best underscores the main difference next year if there should be a nomination and confirmation of a new Chair: namely that he would be arriving and inevitably be facing a market testing of a new Chair who will lack the track record and policy credibility Yellen and to some extent Powell have already established.

In that sense, the “safe hands” bet for the Trump Administration would be a reappointment of Yellen. She would offer the best prospects for anchoring Fed credibility in what could be a volatile policy environment next year amid any lingering “mystery” over inflation dynamics or uncertain fiscal policy.

What’s more, the Yellen-crafted gradual policy normalization strategy is probably the best safeguard to an extended economic growth cycle that will be prized by the Trump White House going into the November 2018 mid-term elections.

The gossip is that the Yellen meeting with President Trump on Thursday did not go especially well, and that the President is leaning towards Powell. But those reports are coming from advisors and especially from Treasury, rather than the President himself.

And today Chair Yellen was back to the White House for a curiously timed lunch with National Economic Council Chairman Gary Cohn. ‎So who knows, and the President should probably be taken at his word, that he is giving a Yellen reappointment serious consideration.

With a major speech slated for later tonight, Chair Yellen is going to get even more media attention than usual, even if her Q&A session will be competing with Game Six of the Yankees-Astros American League pennant series.

A Taylor-led Fed

A Taylor nomination would certainly bring an unmistakable gravitas to the Fed leadership. It is also probably true he would tend towards a more hawkish policy bias on rates going forward in light of the currently solid data and continued above trend growth.

But then, so would Yellen and Powell, and we doubt Taylor in his first year would be so hawkish as to push a fourth rate hike in 2018 unless the data and inflation were truly taking off.

The Taylor-led Fed, for the most part, is a 2019 story in whether a Taylor-led FOMC concludes the longer run neutral rate is rising as the economy heals or indeed how closely policy should hue to the unobservable assumptions. And as to whether or when a Taylor-led Fed would formally adopt a rules-based policy framework, keep in mind that it took former Chair Ben Bernanke, a long time inflation target advocate, seven long years to win over the rest of his FOMC colleagues to adopt the 2% inflation target.

We would also wonder just how much a Taylor-led FOMC would run policy on a hard and fast adherence to a Taylor Rule, especially an untweaked one. For one, what someone says as an outside critic and what they do when on the inside looking out can and usually are two different things.

And as we wrote last week in first reporting how well received he was in his meeting with President Trump (see SGH 10/13/17, “Fed: The Taylor-Powell Leadership Era”), the widely held market assumption he would set off on a hawkish rate path due to the “Taylor Rule” is misplaced.

As Taylor himself noted in his paper at a Boston Fed conference, the rate level under a Taylor Rule depends on the R* penciled into the equation, i.e. if the R* is nudged down to a longer run 3% (or less if going off the current FOMC median) rather than the 4% of the 1990s equation, and we wonder how far from the current path a Taylor FOMC would be.

On the other hand, Taylor also brings a mixed review of his tenure at Treasury as the Undersecretary for International Affairs under President George W Bush, not being especially known for consensus building with counterparts or in managing relations with other arms of the government. So gravitas aside, a Taylor Chair may need a strong Vice Chair to round out the new Fed leadership.

And that, of course, would tend to reinforce the scenario of elevating Powell to the Vice Chair position left vacant by Stan Fischer’s departure, with Randal Quarles, the newly arrived Vice Chair for Banking Supervision filling out the rest of a new triumvirate of Fed leadership.

Powell as Everyone’s Second Choice

In any case, Governor Powell is said to be a clear front-runner, and is often described as just about everyone’s “favored second choice,” neatly meeting the checklist of the White House criteria on both monetary policy and especially regulatory policy.

Powell has ably served under Yellen since his appointment in 2012, as a Republican paired at the time with Democrat Jeremy Stein of Harvard University. Powell has been closely aligned with Yellen throughout the years of the policy normalization strategy and has shown a knack for consensus building in both his Board functions and with staff, as well as outreach to the districts.

Powell has also picked up much of the internal Board responsibilities, such as overseeing the banking supervision tasks after the departure of Governor Dan Tarullo earlier this year. Powell is also close to Quarles, their having worked together at Treasury under President George H. W. Bush.

And aside from the usual rankles from the far Republican right (we assume over his close association with Yellen), Powell would be easily confirmed by the Senate.

Warsh and Cohn Back of the Pack

We think a Warsh or Cohn-led Fed would face altogether different sort of challenges. For Cohn, the question that hangs over him is his lack of experience in the deeper underpinnings of monetary policy and a professional experience shaped by corporate management battles not entirely geared to the cultural contours of a Committee, consensus-style decision making.

The last CEO to take the helm of the Fed was G. William Miller, who is said to have brought an egg timer to the FOMC meetings in a failed effort to speed up the discussions. He was mercifully yanked out of the central bank after barely 18 months to be replaced by the veteran insider Paul Volcker.

For Warsh, a credibility deficit could prove to be especially daunting, not the least of which would be if his arrival is tainted by the perception, unfairly or not, that he won the job in part through favored family connections of his father-in-law’s lobbying or the whispers of the Trump children and son-in-law outside the White House and Treasury vetting process.

There is also said to be some resistance to a Warsh appointment due to his relative young age and questions over his ability to lead on both the policy front in terms of crafting consensus and on institutional issues when he has made such a fierce pitch to “reform” the Fed.

Both Warsh and Cohn would also face problematic confirmation hearings, despite their Republican credentials.

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