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Will the reshuffling of the FOMC change the monetary policy outlook in the United States?

 

The essential

Donald Trump should announce in the coming weeks his choice for the post of chair of the Board of Governors. Because of the recent resignations of Daniel Tarullo and Stanley Fischer, the President has the power to reshuffle greatly and for long the FOMC composition. However, the lack of fiscal room of maneuver does not argue for a radical change of the monetary policy and for a rapid rise of the fed funds.

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02 October 2017

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02 Octobre  2017

 

While the Fed marked a historic milestone on 20 September by initiating the process of shrinking its balance sheet, the question of the reconfiguration of the FOMC has become crucial for the continuation of the fed funds tightening cycle. After Daniel Tarullo in April 2017, Stanley Fischer has just tendered his resignation from the Board of Governors for personal reasons. His resignation will take effect on 13 October. As a result, four of the seven seats on the Board of Governors will be vacant after 13 October (Barack Obama had nominated Allan Landon and Kathryn Dominguez to fill the two posts left vacant in 2015 but the Senate, controlled by the Republicans since the 2014 elections, never confirmed these appointments).

Obviously, this is not the whole story since the term of office of the Chair of the Board of Governors, Janet Yellen, ends on 3 February 2018. The question of her reappointment has been at the forefront of debate since the US presidential campaign and it is now up to Donald Trump to decide whether to reconfirm her or not. Should Donald Trump select another Reserve Bank President for the Board, Janet Yellen could remain on the Board of Governors since her term of office as a governor runs until January 2024 but would she really want to after such a rejection? Should Janet Yellen relinquish her post as a governor, Donald Trump would be free to appoint five of the seven members of the Board.

 

Graph 1 EN

 

There is very great uncertainty swirling around the reconfiguration of the FOMC in 2018.

Let us quickly review how the FOMC works. Theoretically, the Committee is comprised of 12 voting members:

• the seven members of the Board of Governors, all of whom hold permanent voting rights
• the President of the Federal Reserve Bank of New York, who holds a permanent voting right
• four Reserve Bank Presidents, who serve one-year terms on a rotating basis.
There are eight regularly scheduled FOMC meetings per year of which four are more likely than the others to involve a fed funds rate change (March, June, September, and December) because the latest economic projections are presented and a press conference is organised by the FOMC Chairman. Regarding the membership of the FOMC in March 2018, we currently cannot be sure about the identity of six of its 12 voting members: Lael Brainard, Jerome Powell, Bill Dudley and three Reserve Bank Presidents (Jeffrey Lacker still has not be officially replaced as the President of the Federal Reserve Bank of Richmond). Uncertainty as to the identity of the voting members of the FOMC in 2018 is therefore very high.

 

Graph 2 EN
Graph 3 EN

 

Who will be the next Chair of the Board of Governors? Janet Yellen, Kevin Warsh, Jerome Powell or Gary Cohn?

For the moment, Donald Trump has been slower than his predecessors in making his picks for key posts in his administration. Although several seats are vacant on the Board of Governors, he has named only one person so far. He has selected Randal Quarles, who served for several years in the Treasury during the Bush Administration before returning to the financial sector and founding The Cynosure Group, a private equity firm. The confirmation of Randal Quarles by the US Senate should be a simple matter as a number of Democrats have said they would support his candidacy. Randal Quarles is expected to work on matters relating to banking regulation, which he hopes to ease. We have little information regarding his vision for monetary policy, but Randal Quarles recently stated that the Fed’s reluctance to use mechanical monetary policy rules was appalling (“a crazy way to run a railroad”).

According to press reports, Donald Trump is hesitating between reappointing Janet Yellen and nominating Kevin Warsh, Jerome Powell or Gary Cohn.

While the Fed has hiked four times the fed funds and started the reduction of the balance sheet’s size under her presidency, Janet Yellen has indicated (« Inflation, Uncertainty, and Monetary Policy », 26 September 2017) that, with conditions having improved so much on the labour market, the uncertainty requires a fed funds adjustment that is not too rapid (as it may dampen inflation’s rise), but that is not too slow either (as it may cause the labour market to overheat).

Kevin Warsh is another person who Donald Trump has met for the job of chairman of the Board of Governors. Kevin Warsh has worked for Morgan Stanley from 1995 to 2002 before becoming Special Assistant to the President George W. Bush for Economic Policy until 2006. He has become the youngest Fed’s Governor at 35 in 2006. Kevin Warsh has never voted against the FOMC statement but, as Ben Bernanke has explained in his memoirs, he was skeptic about the QE2 program and he only voted for it out of respect for Bernanke. He resigned a few weeks after the announcement of the QE2, at the beginning of the year 2011. Kevin Warsh has been very critical about the Fed recently (« America needs a steady, strategic Fed », WSJ, 30 January 2017) and would like the Fed to hike the fed funds more mechanically in function of the deviations from its employment and inflation objectives. According to him, “the Fed should establish an inflation objective of around 1% to 2%, with a band of acceptable outcomes” and the deviations of inflation from the 2% target for several quarters do not justify the current policy stance.

Governor Jerome Powell is among the people met by Donald Trump for the Fed Chair position. Jerome Powell is a member of the Board since May 2012. Like Kevin Warsh, Jerome Powell is a Republican but his speeches show that his views on monetary policy are very close from that of Janet Yellen.

 

Graph 4 EN

 

Gary Cohn is the current Director of the National Economic Council and is a close advisor of Donald Trump. His profile differs from that of Janet Yellen, Kevin Warsh and Jerome Powell as he has never held a position at the Board of Governors and as he has worked until very recently for Goldman Sachs (1990-2017). He would favour a gradual rise in the fed funds rate.

However, whether Donald Trump nominates Janet Yellen, Kevin Warsh, Jerome Powell or Gary Cohn as Chair of the FOMC, it should not be forgotten that there are three other seats to be filled and that Donald Trump might be able to obtain an FOMC that would set monetary policy that fully aligns with his expectations.

 

For Donald Trump, a policy of rapidly raising key rates is not desirable at a time when government debt is rising by leaps and bounds.

Since taking office, Donald Trump has suffered a number of setbacks on the political front, whether related to the failed repeal Obamacare, lack of action on infrastructure investment or tax reform. One common thread linking these setbacks is opposition from a very fiscally conservative fringe of Republican congressmen (the famous “fiscal hawks”), who regard any increase in government debt as a grave threat to the US economy.

According to last June’s Congressional Budget Office projections, the US deficit will inevitably widen over the next ten years, mainly due to the ageing of the population and hence an increase in the cost of Social Security. As a result, the debt-to-GDP ratio is likely to rise very quickly between now and 2027 (to about 100% by 2027 for federal debt alone). Admittedly, to make its projections the CBO
assumed a gradual increase in the average interest rate paid on the debt up to the limit of 3.50% by 2027 (versus 2.28% in August 2017), a level that might be regarded as fairly low. But a change in the conceptual framework combined with the adoption of the Taylor Rule could vastly complicate things and result in a revision of government debt projections to the upside. The Taylor Rule, introduced by John Taylor in 1993, dictates that the fed funds rate should currently be slightly above 3% instead of within a range of 1% to 1.25%. Rapid convergence of the fed funds rate toward 3% under the Taylor Rule would have two major consequences: 1) a faster than expected increase in the cost of government debt, 2) a negative impact on the economy, possibly leading to recession, which would immediately cause the public deficit to widen. This would further limit the US Government’s margin for manoeuvre.

 

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Conclusion

The uncertainty about the identity of the voting members of the FOMC in 2018 is unusually high. After the resignations of Daniel Tarullo and Stanley Fischer and with the approaching end of Janet Yellen’s term of office as the Chair of the Board of Governors, Donald Trump is free to radically alter the composition of the FOMC and obtain a Fed that could set monetary policy broadly in line with his expectations. That being said, it is clearly not in Donald Trump’s interest to appoint FOMC members who would bring back the long-forgotten Taylor Rule or who would raise the fed funds rate faster than rate projected by the current members of the Committee, because its room for manoeuvre would be a little more limited. Reappointing Janet Yellen, who is in the midst of a gradual normalisation of fed funds rates, would have the advantage of partially silencing the critics of Fed’s low interest rate policy and keeping interest rates low overall, which would slow the progression of government debt. The possible nominations of Jerome Powell or even Gary Cohn would not radically change the Fed’s policy rate. On the contrary, the nomination of Kevin Warsh would lead to a rather clear change, that would lead markets to consider a quicker pace of rate normalization.

 

Graph 6 EN

 

 

DRUT Bastien , Fixed Income and FX Strategy
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