Should he stay or should he go?
Biden’s decision on Powell and others risks market volatility
Inflation has continued to rise over the past several months, even though we’ve lapped the negative readings we experienced at the depth of the pandemic from February through May 2020. Wages are increasing sharply, along with higher food, energy and housing costs, so the Federal Reserve is appropriately on the verge of downshifting its monetary policy accommodation. They may start tapering their $120 billion monthly bond-buying program in a few months, followed by a liftoff in interest rates potentially by the end of calendar 2022.
At the same time, however, a possible leadership transition at the Fed looms. Jerome Powell’s term as chair and Richard Clarida’s term as vice chair both expire at the end of January. Vice Chair for Bank Supervision Randy Quarles’ term ends in October. Along with an open seat (Trump nominee Judy Shelton failed to win confirmation), President Biden can remake the Fed’s seven-member board of governors with four nominations in coming weeks. Typically, presidents announce their picks between August and October, allowing the Senate enough time to conduct due diligence ahead of a confirmation vote.
Financial markets generally hate uncertainty, which is abounding with the imminent inflection point in monetary policy. Consequently, we have added inflation, Fed policy shifts and potential leadership transition to the list of market headwinds that could contribute to our forecast of a 5-10% correction in stocks over August, September and October.
Inflation seems sustainable The core wholesale Producer Price Index (PPI) hit a new record high in August, rising 6.3% year-over-year (y/y). The core Personal Consumption Expenditure (PCE) index, the Fed’s preferred measure of inflation, hit a 30-year high at 3.6% y/y in July (well above the Fed’s 2% target). But the core retail Consumer Price Index (CPI), which rose to a 30-year high of 4.5% y/y in June, eased to 4.3% in July and to 4% in August. While the improvement in CPI over the past two months is certainly good news, we’re watching several underlying inflation metrics closely. They collectively suggest that higher inflation will stubbornly persist well into 2022:
- Average hourly earnings have risen by a strong 6.24% on an annualized basis over the past five months through August.
- Key agricultural commodities (such as corn, wheat and soybeans) have leapt 50-80% over the past 18 months, resulting in sharp increases in meat and dairy prices.
- Housing prices have soared by a record 19% y/y through June, with rental prices up by 10%.
- Energy prices have gone vertical over the past year, with natural gas nearly quadrupling, crude oil more than doubling and gasoline up more than 50%.
Fed shifting gears As a result, investors are becoming increasingly concerned about a potential monetary policy error. We expect the Fed to announce plans for tapering the $120 billion monthly bond-buying program at the Federal Open Market Committee meeting on Nov. 3, if they’ve seen a rebound in the September jobs report released on Oct. 8, which we think will be the case. The taper could end by June 2022, potentially setting the table for a hike in interest rates as early as December 2022. This might be followed with two more quarter-point hikes in 2023.
Powell has done a good job On the merits, we believe that Powell deserves a second term. Wall Street seems to think his reappointment is a slam dunk. He acted aggressively to cut the fed funds rate to zero when the pandemic pushed the global economy into recession in March 2020, orchestrated a successful wealth effect with the bond-buying helping lift the economy out of the deepest recession in history, and was an active supporter of Biden’s goal to achieve broader economic participation for lower-income cohorts.
Progressive pushback While Congressional moderates agree Powell deserves a second term, liberals and progressives are lobbying against his re-nomination. They believe Powell has been too loose with financial regulations for the banking industry and has not advocated forcefully enough in areas such as climate change and advancing racial and economic justice. That’s a problem, in our view, and it means his re-nomination may be closer to a coin flip.
Biden’s picks That intellectual divide creates a potential problem for the administration. With the Fed on the verge of scaling back accommodation to rein in rising inflation, naming a new, more dovish chair might roil markets. The administration has assembled a list of possible nominees to fill the soon-to-be open seats. We think it includes many of the following candidates:
- Lael Brainard, Ph.D. Fed board member
- Roger Ferguson, Ph.D. Fed vice chair under former Chair Alan Greenspan; retired CEO of TIAA
- Raphael Bostic, Ph.D. president of the Atlanta Fed
- Sarah Bloom-Raskin former board member and undersecretary of the Treasury under President Obama
- Janet Yellen, Ph.D. former Fed Chair, now Treasury Secretary
- William Spriggs, Ph.D. professor of economics at Howard University and chief economist of the AFL-CIO
- Cecilia Rouse, Ph.D. professor of economics at Princeton University and current chair of the Council of Economic Advisors (CEA)
- Lisa Cook, Ph.D. professor of economics at Michigan State University and protégé of Yellen at Cal Berkley, focusing on the labor market
- Mary Daly, Ph.D. president of the San Francisco Fed
Solomonic compromise? Biden has been hemorrhaging political capital in recent months, with declining poll numbers due to the ongoing crises in Afghanistan and the southern U.S. border and the spike in inflation, among other issues. As a result, he may very well re-nominate Powell in the hopes of quelling a financial-market uproar. But at the same time, he may select from several of the candidates above to restructure the Fed, mollifying his progressive base. We think a potential strategy might be:
- Re-nominate Powell
- Nominate Brainard for vice chair
- Nominate Bloom-Raskin for vice chair for bank supervision
- Nominate Spriggs to fill Brainard’s board seat
- Nominate Cook to fill the open board seat
This scenario would keep Yellen at the Treasury, Rouse at the CEA, and Bostic and Daly at the Atlanta and San Francisco Feds, respectively. If Biden decides against Powell, Brainard likely would be his choice.