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New seating plan at the Federal Reserve

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Why don’t we start with a show of hands: who was surprised by President Trump’s refusal to reappoint a Democrat as Chair of the Federal Reserve? No hands in the air? Excellent.
 
In talking about Jerome Powell’s soon-to-be leadership of the world’s most powerful central bank, two ideas have quickly taken hold as accepted wisdom. The first is that, as would have been the case for Janet Yellen had she been reappointed, Powell’s primary challenge will be to figure out how to unwind much of the Fed’s $4.5 trillion balance sheet and normalise interest rates without spooking global markets or stymying US growth. The second is that, Herculean though this task seems, he is very much the ‘continuity candidate’ and will therefore have an easier time of it than the alternative candidates would have done.
 
It is difficult to dispute the first of these, but the second is dangerously optimistic and based on a questionable premise. Powell, so the reasoning goes, is broadly centrist on monetary policy, and has spent his tenure as Fed governor supporting Yellen’s gradual (some might say glacial) tightening of interest rates. With this record, he is unlikely to start rocking the boat now and will in all likelihood continue to pursue the same path during his own chairmanship. Businesses and market participants therefore have a good basis for their expectations of future policy, and should be able to endure the withdrawal of monetary stimulus with less turbulence than they otherwise might have done. The argument is not unreasonable, but it glosses over some significant discontinuities marked by this nomination.
 
Start with what it says about the Fed’s political independence. Since Paul Volcker took over leadership of the organisation in 1979, every chair who has been in the role to witness the swearing in of a new president has been reappointed by that president. This practice persisted through changes in party (Alan Greenspan in particular was nominated by Ronald Reagan, and subsequently reappointed by each of George HW Bush, Bill Clinton, and George W Bush) and sent out an important message about the bipartisan desire for a monetary policy that would support growth, while ensuring low inflation, and stable employment. It also acknowledged that while it may be impossible to disentangle the cost of borrowing from political considerations, assessing its impact on the rest of the economy is a technical, not a political, task. A democracy loses nothing by entrusting such a task to a technocrat, and gains a great deal from ensuring that their decisions are not governed by whatever happens to be politically expedient. After all, the history of leaders who allowed themselves to print their own money is one of those who could not resist the temptation to do so to excess, debauching the currency in the process and frequently causing intolerable levels of inflation. With the current president having gone through the usual motions of criticising easy monetary policy while in opposition, only to find himself rather keener on the idea of cheap borrowing once in office, the parallels are not encouraging.
 
That is not the only forty-year ‘first’ marked by Powell’s nomination, as he will also be the first non-economist to take the role since G William Miller’s appointment in 1978. Miller came in at a difficult time for the organisation, inheriting CPI inflation of 6.7%. Believing that this was merely the result of a rising oil price and would be self-correcting (forgive me if it all sounds a little familiar), he refused to raise interest rates despite the urging of the rest of the FOMC. By the end of the year, the dollar was down 12.5% on a trade-weighted basis, and a whopping 42% against the yen. The Carter administration was forced to respond by launching a ‘dollar rescue package’, comprising IMF borrowing, emergency sales of US gold stock, and the issuance of Treasury securities in foreign currencies. The package was enough to prop up the currency for a brief period, but not sufficient to prevent inflation from rising to 14% by 1980, at which point Volcker was in position to administer his ‘shock therapy’ and rein in spiralling prices – but not before the level of Fed funds had hit what would now be viewed by many as an astronomical 20%.
 
None of this is intended to suggest that Powell will not be an entirely able and successful chair. In the current climate, no candidate could take the reins without a keen awareness of the political pressure that would be placed upon them – and nor is this situation unique. A somewhat politically motivated appointment to the job may be a break from the tradition of recent years, but it is a far cry from the pronouncements of President Truman’s days, when a White House letter to the FOMC stated that were they to raise rates they would be doing “exactly what Mr Stalin wants”. And while Powell may lack an academic background in economics, that is not at all to suggest that he is not an expert on the effects of monetary policy, having served as a Fed governor since 2012 and in the Treasury under George HW Bush before that.  
 
Nevertheless, it is pointless to deny the challenges that he will face, especially in the face of a market yield curve which currently undershoots the Fed dot plot by 0.75%, or three hikes over the next two years. It will take some delicate steering to realign expectations without prompting a sell-off, and any appearance of political pressure being brought to bear – whether real or imagined – will not make the task any easier.
 
Outside the US, observers to the drama hardly have a lower stake in the outcome. If there is one thing that we can learn from looking at the last 50 years of history, it is that neither inflation nor any consequent changes to monetary policy in the US will take long to spill over into the UK economy. It is for this reason, amongst others, that the ‘forward guidance’ given by the present Governor of the Bank of England has always seemed a little odd, suggesting as it does that the Monetary Policy Committee has complete independence in setting the UK base rate. In reality it will almost always need to either follow an FOMC hiking cycle with one of its own, or face a depreciation in sterling that would make the post-referendum devaluation seem like a minor blip.
 
In this context, perhaps the market reaction to last week’s MPC announcement – a 10 basis point drop in the 5 year swap rate, accompanied by a sell-off in sterling, despite the news of a 0.25% increase to the base rate – was not so surprising after all. The Bank’s Inflation Report, which accompanied the announcement, repeatedly stated that its conclusions were “conditioned on the gently rising path of Bank Rate implied by current market yields”. But if there is one thing we can say about the market yield curve with virtual certainty, it is that it will always be wrong – the only questions are in which direction and to what degree? While UK interest rates may yet undershoot market expectations, there is precious little room for them to do so. On the other hand, if they are to overshoot, the sky is the limit.
 
Upcoming Economic Releases
After the excitement of last week, the coming few days are quieter ones for data. That said, Tuesday sees the release of the Eurozone Retail PMI as well as September’s Retail Sales growth (expected at 2.8% YoY after last month’s 1.2%). The ECB will publish its Economic Bulletin on Wednesday, and then on Thursday we will see UK Manufacturing Production (expected to be up 2.4% YoY, from 2.8% last month) and UK Construction Output (expected at 1.7% YoY, down from 3.5% last month). 

 

All views expressed here are the author’s own and are based on information available at the time of writing

 

 

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