Markets brace for nomination of next Fed chair

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By:
Peter Lee
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The lead candidate, Fed insider Jerome Powell, promises continuity and investors would no doubt be relieved to see him step up, but they might swoon if Trump nominates persistent Fed critic John Taylor.


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Fed insider Jerome Powell, Fed critic John Taylor, Fed chair Janet Yellen


US president Donald Trump has indicated he will decide who should be the next chair of the US Federal Reserve before he leaves for Asia on Friday.

If Janet Yellen is not reappointed, the odds have been shortening on Jerome Powell, a former lawyer and investment banker, who was a partner at the Carlyle Group from 1997 to 2005, to win the nomination.

Powell, though not a trained economist – he took degrees in politics and law, and served as undersecretary of the Treasury under president George HW Bush, with responsibility for policy on financial institutions, the Treasury debt market and related areas – would be greeted by investors as very much the continuity candidate.

Powell joined the board of governors of the Federal Reserve five years ago and sources suggest he has been in training for the top job throughout his term on the board and really wants it.

Joseph Lavorgna, chief economist for the Americas at Natixis, points out: “Powell, who has been a governor since May 2012, has consistently voted with the Yellen-led consensus. So, by all indications, he was completely on board with quantitative easing (QE) Part 3 in September 2012 and the Fed’s announcement last month to begin balance-sheet normalization.”

“As such, markets should take a Powell announcement largely in stride,” according to Peter Hooper, chief US economist at Deutsche Bank, and see it “keeping financial conditions easy and providing little disruption to an economy that is experiencing solid growth.”

Hooper argues that Powell has learned well on the job, pointing to his speech earlier this year on the supply side of the economy to the Forecasters Club of New York.

“His speech was followed by 45 minutes of being peppered with questions about current monetary policy and economic conditions by approximately 60 Wall Street economists in attendance, and his performance was flawless,” Hooper reports.

That allows some confidence both in his ability to build consensus within the Fed and to communicate with markets.

Skittish

Investors might turn more skittish if the other much-touted candidate, John Taylor, gets the presidential nod, assuming that he would likely pursue a faster course to raising rates than that mapped out by Yellen and possibly a more aggressive run down of the balance sheet too.

His eponymous rule lays out a mechanistic relationship between nominal Fed rates and deviations of inflation from the Fed’s own target.

“At present, the Taylor Rule is pointing to a much higher funds rate than its current 1.00% to 1.25% range,” Lavorgna at Natixis points out, so “on the surface, the financial markets’ concerns are well placed.”

For many years, Taylor has been critical of the Fed for holding policy rates too low for too long and for the use of balance-sheet policy to combat the great recession and its aftermath, Deutsche’s Hooper points out.

The economist adds: “His criticisms are an advantage in the eyes of conservative Republicans in Congress and the administration. But they are a disadvantage when it comes to his ability to lead the FOMC (Federal Open Market Committee) – as well as the Fed staff – and his potential impact on financial markets.”

Andreas Johnson, economist at SEB, points out that even after this week’s nomination is announced, additional vacancies on the Board of Governors will provide Trump with the opportunity substantially to reshape the Fed’s leadership.

“We expect the Fed to become more hawkish in 2018,” he says. “Incoming regional Fed presidents are more likely to hike rates than their outgoing predecessors.”

Trump’s mind is never easy for outsiders to read and no doubt there is plenty on it right now. Just a few weeks ago, it was a popular bet that he might reappoint Yellen. With just days to go before the president’s own self-declared decision date, Predictit, the traded market in political decisions, seems to be indicating an 80% chance of Powell taking the seat in February.

Some economists wonder whether, if Trump wants both men on board, Taylor might take the position of vice-chair in a Powell Fed: but they struggle to see Powell submitting to a position beneath Taylor.

Instincts

While investors ponder the hawkish or dovish predilections of the various candidates, it is not certain how their instincts might play out, as the presidential administration tries to push through Congress a tax cut that might bring a big short-term boost to the economy, but generate new concerns about deficits and debt levels.

Lavorgna suggests that in the event a tax-induced increase in growth puts upward pressure on wages as firms bid for a limited supply of potential labour, the so-called continuity candidates – Yellen and Powell – might turn more hawkish, while Taylor might be more patient in raising rates because his political tendencies lean to the supply side.

“Investors should not jump to conclusions as to who is dovish or hawkish,” he says. “In the current environment, where the administration is trying to pass tax reform, traditional labelling may be incorrect.”