Orlando's Outlook: Is Fed's leadership transition a market risk?


Bottom line There are two potentially significant market risks associated with the Federal Reserve at this time—policy and leadership transition. We plan to discuss the implications surrounding policy issues, such as shrinking the Fed’s balance sheet and additional interest-rate hikes, in a separate Orlando’s Outlook on August 25, when the Fed is hosting its annual monetary policy symposium at Jackson Hole, Wyo. But with Janet Yellen’s 4-year term as Fed chair set to expire in February, we are devoting this week’s missive to analyzing President Trump’s options to either reappoint or replace her. So why are we discussing this now, some six months before the eventual day of reckoning? Because four years ago during the summer months, recall that President Obama very publically weighed whether to reappoint Fed Chairman Ben Bernanke to a third term, or to nominate his Treasury Secretary Larry Summers or Fed Vice Chair Yellen to replace him. That uncertainty sparked a 5% equity-market correction during August. So let’s take a closer look at Trump’s potential candidates for the Fed chair.

Hawk or dove? During last year’s highly contentious presidential election, candidate Trump was openly critical of the Fed in general and of Yellen in particular, alleging that political bias in policy-setting decisions was keeping interest rates unduly low and pressuring the dollar. It appeared at the time that, if Trump somehow did manage to win the election, there was virtually no chance that he would retain Yellen.

Last November’s stunning election results, however, changed that political and economic calculus. Although candidate Trump did not speak highly of Yellen during his campaign, he has a different perspective now that he’s sitting in the Oval Office, as he now fully understands and appreciates that lower rates and a weaker dollar are beneficial for the economy. Witness corporate results in the first half of 2017, the strongest earnings growth we have enjoyed in six years. Trump may be more inclined today to keep the dovish Yellen in office, and we think it’s a coin flip as to whether Trump reappoints her. However, it’s also possible that Yellen has no interest in serving a second term, given the state of chaos in Washington. So Trump needs a back-up plan anyway.

Probably 50% odds Trump reappoints Yellen Named by Obama in 2014, Yellen, 70, was the first woman to lead the Fed in its 100-year history, after serving as Bernanke’s vice chair. She graduated summa cum laude with an economics degree from Brown University in 1967 and got a Ph.D. from Yale University in 1971. An academic, Yellen was a professor at Harvard, the London School of Economics and the University of California at Berkeley. From 1994 to 1997, she served as a governor on the Federal Reserve Board and as an advisor for the Congressional Budget Office (CBO). In 2004, she became the president of the San Francisco Fed. Yellen also served as the chair of the Council of Economic Advisors (CEA) under President Clinton. A dove and a Keynesian who believes markets are inherently flawed and in need of government intervention, she became the first Democrat in almost 30 years to lead the Fed. In our view, she’s done a terrific job digging into the weeds of the labor market with her multifactor employment dashboard.

Plan B? In the event Trump decides to go in another direction, he has put together a search committee headed by Gary Cohn, 56, director of the National Economic Council (NEC). Ironically, Cohn is rumored to be one of Trump’s top choices to replace Yellen. But we envision three potential problems with his candidacy:

  • Education Cohn graduated with a bachelor’s degree from American University’s Kogod School of Business. If nominated, he would be the first Fed chair in four decades without a Ph.D. in economics. The only other person to lead the Fed without an economics background was G. William Miller in 1978-79 under President Carter. Miller’s unsuccessful Fed tenure was marked by soaring inflation, stagnant economic growth and a weak dollar, and he left after only a year and a half to become Treasury Secretary. Knowing that history, Cohn may have trouble receiving Senate confirmation.
  • Government Sachs Cohn, a Democrat, joined Goldman Sachs in 1990, and rose to president and chief operating officer by the time he was recruited by Trump to join his administration. Although he enjoyed a successful 26-year investment-banking career at Goldman, he has been criticized for his close relationship to the banking industry.
  • Trumponomics on life support? In conjunction with Trump’s current Treasury Secretary Steven Mnuchin, 54, also a Goldman alum, Cohn is spearheading Trump’s tax reform proposals. The market’s legitimate concern is that if Cohn left the NEC and his role as one of Trump’s key fiscal-policy advisors before tax reform was completed, it would signal diminishing odds of reform actually happening over the next six months.

The field

If Trump opts for a more traditionally hawkish Republican economist to lead the Fed, he likely will choose from among the following mainstream candidates:

  • Kevin Warsh, 47, worked in Trump’s campaign as an economic advisor, and he is thought to be near the top of the list. Like Cohn, though, Warsh does not have a Ph.D. in economics. But he did obtain a B.A. from Stanford University and a J.D. from Harvard Law School. A Fed governor from 2006 to 2011, Warsh served as special assistant to the president for economic policy and as executive secretary of the NEC from 2002 to 2006 under President George W. Bush. Warsh also spent seven years at Morgan Stanley.
  • John Taylor, 70, is thought to be the most hawkish of this group, largely because of his well-known “Taylor Rule,” an approximation to how nominal interest rates respond to changes in inflation, output and other economic conditions. Taylor graduated summa cum laude from Princeton University in 1968 and obtained his Ph.D. from Stanford in 1973. He has worked as an economic advisor for several presidential campaigns, including those of Bob Dole, Bush and John McCain, and was a senior economist on the CEA under President Ford and President Carter. From 2001 to 2005, Taylor served as undersecretary of the Treasury for international affairs, responsible for currency markets, international development, oversight of the International Monetary Fund and the World Bank, and policy coordination with the G-7 and G-20.
  • Greg Mankiw, 59, is a macroeconomist who lies somewhere in the middle of the dove/hawk spectrum, although he is more hawkish than Yellen. He graduated summa cum laude from Princeton in 1980 and in 1984 earned a Ph.D. at MIT, where he studied under current Fed Vice Chair Stanley Fischer. Mankiw served as chairman of the CEA under Bush from 2003 to 2005 and has been an advisor to the CBO and the Federal Reserve Banks of Boston and New York.
  • Glenn Hubbard, 58, is Dean of the Columbia University Graduate School of Business. He has B.A. and B.S. degrees, graduating summa cum laude from the University of Central Florida, as well as a M.A. and Ph.D. in economics from Harvard. Hubbard served as deputy assistant secretary for tax policy at the Treasury from 1991 to 1993 and was the chairman of the CEA under Bush from 2001 to 2003. He is thought to be more hawkish than Mankiw, but not as extreme as Taylor.
  • Martin Feldstein, 77, is a graduate of both Harvard College and Oxford University. He was president of the National Bureau of Economic Research (NBER) from 1978-2008, during which time he also served as chairman of the CEA under President Reagan from 1982 to 1984. Feldstein served as president of the American Economic Association in 2004 and led the President’s Foreign Intelligence Advisory Board under Bush in 2006. In 2009, Obama appointed him to his Economic Recovery Advisory Board.
  • Jerome Powell, 64, has been a member of the Fed’s Board of Governors since 2012. He received an B.A. in politics from Princeton University in 1975 and a J.D. from Georgetown University in 1979. Powell served as undersecretary of the Treasury under President George H.W. Bush, responsible for policy on financial institutions and the Treasury debt market. He also has an extensive commercial banking background with senior executive positions at Bank of America, Security Pacific and U.S. Bancorp.

Let’s make a deal

Trump’s shocking election victory last November has resulted in an unconventional presidency thus far, to be sure. We’re frustrated with the chaos in Washington and the lack of legislative progress on his key fiscal-policy initiatives to date. Our Orlando’s Outlook on June 14, 2017 (“Just Say No”) outlined the Democrats’ political strategy to resist all of Trump’s legislative priorities.

Anxious to break the logjam in Washington, get some wins on the board before next spring and get the economy rolling in 2018 ahead of the midterm elections in November, we believe that President Trump may reach across the aisle to the Democratic Congressional leadership in an effort to broker a bipartisan deal, using the Fed chairmanship as a possible bargaining chip.

In this scenario, Trump could invite Senate minority leader Chuck Schumer and House minority leader Nancy Pelosi to the White House soon, looking to solicit their thoughts on the upcoming leadership opening at the Fed, and offering to retain Yellen. If this happened, might the Democrats in Congress be more receptive to supporting some low-hanging legislative fruit on which both parties already agree in principle, such as corporate tax reform, repatriation, and infrastructure spending?

One curveball, of course, is if Yellen has no interest in serving a second term under Trump, even if she were nominated, in which case he needs a wild-card back-up plan:

  • Lael Brainard, 55, a Democrat who has been a Fed governor since 2014. She could be one of the most surprising but strategically smart options for Trump. Along with Yellen, Fischer, and New York Fed president Bill Dudley, Brainard is thought to be one of the Fed’s key monetary-policy inner-circle stalwarts. She received her B.A. with honors from Wesleyan University in 1983, and graduated with an M.S. and Ph.D. in economics from Harvard. She served as deputy National Economic Advisor to Clinton, as well as his personal representative to the G-7 and G-8. In 2009, she became a counselor to the Secretary of the Treasury and a member of the Financial Stability Board, and from 2010 to 2013, she served as undersecretary of the Treasury under Obama. Brainard also worked at McKinsey & Co.

While we are the first to admit the odds of this scenario playing out are low, we don’t believe they are zero. Brainard would be a talented Fed chair who shares Yellen’s more dovish bias, so Trump would potentially be getting a Democratic Fed chair more dovish than any of his Republican options, which could help to support lower interest rates, a weaker dollar and a stronger economy.

Democrats, at least in theory, would be happy with Trump’s compromise choice of one of their own, Trump’s poll numbers among women would likely improve with his bold choice to counter misogynistic criticism and he could possibly gain some much-needed political leverage to get important fiscal-policy reforms passed in Congress.

Research assistance provided by Federated summer intern Victoria Sanzo