Orlando's Outlook: Reshaping the Fed


Bottom line As we approached last November’s contentious presidential election, we felt that the wide-ranging impact of the election would make it the most important in at least a generation. Sure, control of the White House and Congress was at stake. But there was also one Supreme Court seat to be filled immediately, and perhaps as many as three more over the next few years—which has the potential to reshape our judicial branch. Moreover, with Janet Yellen’s term as Federal Reserve chair set to expire on Feb. 3, 2018, the next president would also help to determine the central bank’s future leadership.

But with Jerome Powell’s recent nomination to replace Yellen as chair, Stanley Fischer’s early retirement as vice chair, New York Fed President Bill Dudley’s plan to retire next year and three other open seats on the board of governors, we’re also witnessing a leadership transition that will reshape the Fed. This has the potential to impact monetary policy, economic growth and financial-market performance.

Powell to replace Yellen as the Fed’s 16th chairman Last week, President Trump nominated Jerome (Jay) Powell, 64, to replace Yellen. The Senate Banking committee will hold a confirmation hearing Nov. 28. The Senate confirmed him to the board of governors in 2012 by a 74-21 vote to fill an unexpired term, and he was confirmed again in 2014 by a 67-24 vote for a full 14-year term.

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 extensive legal, private equity and commercial banking experience with senior executive positions, most prominently at Carlyle Group. With a B.A. in politics from Princeton University in 1975 and a J.D. from Georgetown University in 1979, Powell is the first Fed chair since Paul Volker 30 years ago to not have a Ph.D. in economics.

According to the Wall Street Journal, Powell’s nomination also marks the first time in nearly 40 years a new president chose not to ask the existing Fed chair to stay on for another term, even though the existing Fed chair was originally nominated by a president from a different party. President Reagan renominated Volker, President Clinton renominated Alan Greenspan and President Obama renominated Ben Bernanke. But in 1978, President Carter instead chose G. William Miller to replace Arthur Burns.

Perfect compromise choice? In many ways, Powell appears to have been a solid choice from among Trump’s half-dozen or so rumored options:

  • Monetary policy Powell agrees with Yellen’s dovish approach to policy, in which she gradually raised the fed funds rate in four quarter-point increments over the last two years, and has just begun to slowly shrink the Fed’s $4.5 trillion balance sheet to perhaps $2.5-3 trillion over the next three years. Her policies have kept the dollar relatively weak versus foreign currencies, which has served as a tailwind for domestic exports and has helped to spark stronger economic growth and stock market performance. The financial markets appear comfortable with this continuity.
  • Mortgage-backed securities (MBS) In addition, Powell may not run down the MBS portion of the Fed’s balance sheet to zero, as Yellen and Bernanke had publicly advocated, which may provide greater support for the housing market.
  • Regulatory reset Trump believes that regulatory overreach by the Obama administration contributed to a slower-than-normal economic rebound from the Great Recession, and he has already rolled back more than 800 Obama-era federal regulations. Trump would prefer to reset the regulatory pendulum toward the center, and Powell appears amenable to tweaks in the Volker Rule, Dodd-Frank and the DOL rule, among others.

So why is Yellen out? During last year’s presidential election campaign, Trump was critical of the Fed in general and Yellen in particular, alleging that political bias in the policy-setting decisions was keeping interest rates unduly low and the dollar weak. But as president, he has benefitted from both, as GDP growth of more than 3% over the past two quarters is the best in three years, and double-digit corporate profit growth thus far in 2017 is the strongest in six years. The S&P 500 has rallied nearly 25% over the past year to reflect these improved fundamentals.

We believe Yellen did not wish to serve a second term, given the current state of chaos in Washington. As a result, she used her keynote speech at the Fed’s annual monetary policy symposium in Jackson Hole, Wyo., on Aug. 25 to deliver an academic speech on the wisdom of the federal government’s post-recession regulatory efforts. In our view, that reduced the odds that Trump—who liked her dovish approach—would pick her.

To support our admittedly controversial view, Fischer, less than two weeks after Yellen’s Jackson Hole speech, surprised investors with his own resignation on Sept. 6 (effective Oct. 13), well ahead of his term expiring in June 2018, due to “personal reasons.”

Yellen completes her punch list Knowing that she may only be a one-term Fed Chair, we believe Yellen has been actively managing her to-do list:

  • Complete the tapering process (on the Fed’s $85 billion in monthly bond purchases) that was started by Bernanke in late 2013 just before he retired, which she accomplished by the end of 2014.
  • Lift off from the Fed’s zero interest-rate policy (ZIRP), which she accomplished with her first quarter-point rate hike in December 2015.
  • Begin to shrink the Fed’s $4.5 trillion balance sheet, which she accomplished last month, with the implementation of a gradual 3-year schedule.
  • Avoid a double-dip recession, which we believe is no earlier than 2020-21.

Could Yellen stay on as a member of the board of governors? Yellen, 70, was named by Obama in 2014 as the first woman to lead the Fed in its 100-year history, after serving as then-chairman Bernanke’s vice chair. Although her term as chair expires next February, she has 10 years left on her term as a member of the board of governors, and she has not yet decided whether she will stay. Because Powell does not have a Ph.D., and because Trump has not yet chosen a vice chair to replace Fischer, Yellen could stay on temporarily to help ease Powell’s transition. Yellen earned a Ph.D. in economics from Yale University in 1971.

Who might be the Fed’s next vice chair? Much like Trump’s options to chair the Fed, we suspect he may be looking at some of the same candidates, with an emphasis on academic credentials, to help Powell manage the Fed’s staff of talented economists.

  • John Taylor, 70, author of the well-known “Taylor Rule,” an approximation to how nominal interest rates respond to changes in inflation, output and other economic conditions. Taylor obtained his Ph.D. from Stanford University in 1973.
  • Glenn Hubbard, 58, currently Dean of the Columbia University Graduate School of Business, has a masters and Ph.D. in economics from Harvard University. Hubbard served as deputy assistant secretary for tax policy at Treasury from 1991 to 1993 and was the chairman of the CEA under George W. Bush from 2001 to 2003.
  • Greg Mankiw, 59, is an economist with a Ph.D. from MIT in 1984, where he studied under Fischer. Mankiw served as chairman of the CEA under Bush from 2003-05.
  • Martin Feldstein, 77, is a graduate of both Harvard College and Oxford University. He was the president of the National Bureau of Economic Research (NBER) from 1978-2008, during which time he also served as chairman of the CEA under Reagan from 1982 to 1984. Obama appointed him to his Economic Recovery Advisory Board in 2009. Feldstein wrote an op-ed in the Wall Street Journal this week entitled “Corporate Tax Reform is the Key to Growth.”

Randal Quarles was confirmed in October as newest member of the Fed’s board of governors, and he is the first to hold the title of vice chairman in charge of bank oversight. Nominated by Trump, Quarles is expected to add a softer regulatory touch to the Fed, as he replaces Daniel Tarullo, who resigned in April. So with Quarles, Powell, Yellen and Lael Brainard currently on board, that leaves three openings for Trump to fill, which could become four if and when Yellen chooses to leave. Clearly, then, Trump will have an opportunity to significantly reshape the Fed’s board of governors.

Dudley plans to retire as the president of the New York Fed mid-next year. Dudley, 64, has been at the Fed since 2007, after two decades with Goldman Sachs, most recently as chief economist. While the other 11 regional Fed banks have a rotating vote, the New York president always does, and Dudley was part of the power trio—along with Yellen and Fischer—which has successfully guided Fed policy in recent years. Unlike members of the board of governors, however, Fed bank presidents are not political appointees. So Dudley’s replacement will be chosen and confirmed over the next eight months or so by a committee of the board.

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