Special Report
The Federal Reserve faces unprecedented turnover in its Board of Governors over the coming year. The recent resignation of Stanley Fischer occurred when three of the Board's positions were already vacant and there is the additional issue that Janet Yellen's term as Chair ends in January. It remains far from clear that she will be offered another term or would even choose to stay if given the chance.1 Even Governor Lael Brainard's position could change - her willingness to stay on at the Fed may depend on who is the next Chair and on the other Board appointments. The point is that President Trump has the opportunity to choose the people who will run the nation's monetary policy for years to come. The first Board appointment will be Randal Quarles, nominated to be vice-chair for supervision, a position created by the 2010 Dodd-Frank Act to oversee the banking industry. His nomination was recently cleared by the Senate Banking Committee and he should soon be accepted by the full Senate. Quarles has indicated that his position on financial regulations is much softer than that of Yellen. Not surprisingly, there are widespread concerns about the looming changes to the Fed's Board. There are fears that new appointments may lack appropriate expertise and/or that they will have an intellectual bias that could result in overly tight or overly easy policies. Most Fed Chairmen have been highly-regarded economists with extensive experience in policymaking. One notable exception was G. William Miller, who served as Fed Chair from March 1978 until August 1979. Mr. Miller, appointed by President Jimmy Carter, came from a business background - he was CEO of the conglomerate Textron Inc. His short tenure at the Fed was regarded as a failure because he did not take tough action to deal with a growing inflation problem. That challenge was left to his successor, Paul Volcker. Many names have been touted as possible successors to Janet Yellen, including former Fed Governors Kevin Warsh and Larry Lindsey, Professors John Taylor and Glen Hubbard, and former bank CEOs Richard Davis and John Allison. Media reports suggest that the previous front-runner, Gary Cohn, is out of consideration following his criticism of President Trump's response to the Charlottesville clash between right-wing extremists and their objectors. How much will it matter to the economy and markets which person is chosen? The Fed's Scorecard Monetary policy is important because its sets the short-term price of a very important commodity - money! If the price is set too low, then financial excesses are virtually inevitable and if the price is set too high then economic activity is choked off. Yet knowing exactly where to set that price is no simple matter. The appropriate level of short-term interest rates is not observable and is a function of many variables, including the amount of slack in the economy, inflationary pressures, the level of financial conditions, and international factors. The Fed uses different economic models to help its decision making, but these have proved to be of dubious value. As we highlighted in an earlier report this year, the Fed has failed to forecast every recession during the past 60 years (Table 1).2 Yes, the Fed has been successful in achieving low and relatively stable inflation, but only after major policy errors during the 1960s and 1970s allowed inflation to spiral out of control. Table 1Fed Economic Forecasts Versus Outcomes The Fed's Open Market Committee (FOMC) is not run as a dictatorship, yet the person at the helm does have real power. Weak leadership was partly responsible for the inflationary policy errors of the 1960s and 1970s and the strong hand of Paul Volcker was important in launching the attack on inflation in the 1980s. The aura of invincibility surrounding Alan Greenspan during the second half of his tenure as Fed Chair cowed opposition from other FOMC members and contributed to the major error of weak regulatory oversight during a massive buildup of financial imbalances in the 2000s. Central bankers have long believed that price stability is a key prerequisite for maximizing an economy's potential. If we judge the effectiveness of post-WWII Fed leaders solely by the performance of inflation during their tenure, then Chart 1 shows we must give failing grades to those in charge during the 1950s, 60s and 70s - William McChesney Martin (1951-1970), Arthur Burns (1970-78) and G. William Miller (1978-79). Subsequent Chairs get passing grades - Paul Volcker (1979-87), Alan Greenspan (1987-06), Ben Bernanke (2006-2014) and Janet Yellen (2014-). However, it is not quite as simple as that. The Fed has a dual mandate - the Federal Reserve Act requires that policy achieves maximum employment as well as stable prices. And the Fed also plays an important regulatory role in maintaining financial stability. Chart 1The Fed's Record With Its Dual Mandate If we also take account of trends in the labor market and financial stability, the performance of Fed Chairs alters a bit. The second panel of Chart 1 shows the difference between the unemployment rate and its full employment level (based on estimates by the Congressional Budget Office). The Chairs who presided over rising inflation also managed to keep unemployment low for most of the time. And the cost of Volcker's attack on inflation was a deep recession and spike in unemployment. On average, Greenspan's record on growth and thus unemployment was good, but as we noted, he allowed an unprecedented buildup of financial excesses. This helped to create the conditions for the deepest economic and financial downturn since the 1930s but it was his successor, Ben Bernanke, who had to deal with that problem. Another way to assess the Fed's record is to compare the actual funds rate to the level implied by the Taylor Rule. Professor John Taylor's rule calculates the appropriate funds rate based on the deviation of inflation from 2% and the gap between real GDP and its full employment level. The starting point is the assumption that the real equilibrium rate is 2%. If, for example, inflation was above target and the economy was operating above potential, then the rule would require a real funds rate above 2%. There is a widely-accepted view that the real equilibrium rate declined after the 2007-09 downturn so, in our calculations, we use a level of 0.5% after 2007.3 Chart 2 shows that rising inflation of the 1950s, 60s and 70s coincided with the funds rate being kept below the level implied by the Taylor Rule estimate. Not surprisingly, Volcker had to push the funds rate far above normal to start the disinflation process. Subsequently, both Greenspan and Bernanke kept the funds rate relatively close to the Taylor-implied level. Yellen has kept the rate below our estimate and Taylor has been a critic of the Fed's easy money policies. However, some studies suggest that the real equilibrium rate may be even lower than the 0.5% we have assumed. Chart 2The Fed Funds Rate: Actual Versus The Taylor Rule Which Fed Chair was best for investors? Chart 3 shows real return indexes for bonds and equities. Not surprisingly, bond returns performed poorly during the periods of rising inflation and Volcker's reign coincided with the start of a long-term bull market. The equity market rose strongly under Martin, helped by a healthy economy, but in terms of annualized returns during the various Chairs, Volcker takes first place. The real returns for both markets are summarized in Table 2. Although the market did well under Greenspan, the severe bear market of 2000-02 occurred under his watch and, as previously noted, his regulatory lapses set the scene for the 2007-09 market debacle. Yellen had the second-best returns among the Fed Chairs listed for both bonds and stocks, highlighting the power of zero interest rates and quantitative easing! Chart 3The Fed And Market Returns Table 2Fed Chairs And Market Returns So What? The errors made by policymakers to some extent reflect the biases created during their formative years. For example, for those in charge during the 1950s and 60s, fears of renewed depression probably outweighed those of inflation. And the experience of runaway inflation in the 1970s cemented a powerful anti-inflation bias in those central bankers who gained experience during that time. Volcker was in the Fed before inflation took root, but one could argue that whoever had taken over from William Miller would have been forced to take tough action. Inflation was such a severe problem that no Fed Chair could have allowed it to continue. While Volcker deserves a lot of praise, it should be noted that inflation declined in virtually all industrial countries during the 1980s and beyond, even in cases where central banks had not yet achieved independence. The U.S. was in the vanguard of fighting inflation, but the trend in inflation rates was broadly the same in the U.S. and in the median of 18 other industrial countries (Chart 4). Chart 4The Fed Was Not Unique In Driving Down Inflation At the swearing-in ceremony for Fed Chair Arthur Burns, President Richard Nixon reportedly said "I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed". Burns did indeed take an overly soft line on inflation. It is widely assumed that President Trump would prefer someone who will maintain a low interest rate policy in order to support economic growth. It would be a particular concern if the U.S. Administration were to fill the Fed Board with people who had little or no economic and/or policy experience. With the looming departure of Stanley Fischer, there already is a worrying dearth of policy expertise and institutional memory on the Board. President Trump has shown a predilection to favor successful businesspeople for senior cabinet posts and the William Miller's record is not encouraging in that regard. However, it is doubtful that the Senate would approve a full slate of new Board members that is completely devoid of appropriate experience. Moreover, some of the people being touted as possible successors to Yellen, most notably John Taylor, Kevin Warsh and Glenn Hubbard are respected economists who would not be political puppets in pursued of irresponsible policies. If Quarles joins the Fed Board he will push for an easing in bank regulations and will likely get the support from the Chair if a former bank CEO replaces Yellen. However, there would be severe pushback from the staff and other Governors. With memories of the 2007-09 downturn still relatively fresh, Congress also may be wary of a major rollback of regulations. Some Dodd-Frank regulations may be eased - especially for community banks - but we do not anticipate a return to a systemically-dangerous lax regime. What about the Fed's vulnerability to attempted interference from the Administration? Even if President Trump managed to install a new Chair that he deemed loyal and who shared his policy visions, this person would face challenges. The Fed staff is powerful and would make strong arguments against policies they believed to be inappropriate. Importantly, the policymaking process is a lot more transparent now than in the days when Fed Chairs Burns and Miller bowed to political influence. The publication of Fed economic forecasts and detailed meeting minutes would quickly highlight internal policy disagreements and financial market pressures would come into play. And while the Administration gets to nominate people to the Fed's Board, it is not able to remove them. A bigger concern is the possibility that Congress could pass legislation to audit the Fed, including its policy decisions. Earlier this year, the House Committee on Oversight and Government Reform approved the Federal Reserve Transparency Act of 2017, a bill sponsored by Rand Paul, a frequent Fed critic. The bill "directs the Government Accountability Office (GAO) to complete, within 12 months, an audit of the Federal Reserve Board and Federal Reserve banks. In addition, the bill allows the GAO to audit the Federal Reserve Board and Federal Reserve banks with respect to: (1) international financial transactions; (2) deliberations, decisions, or actions on monetary policy matters; (3) transactions made under the direction of the Federal Open Market Committee; and (4) discussions or communications among Federal Reserve officers, board members, and employees regarding any of these matters." Attempts to pass similar legislation in the past have failed, but President Trump is apparently in favor, as are many in Congress. The Fed Chair already faces twice-yearly interrogations by the House and Senate Banking Committees and that has not impacted policy decisions. Nevertheless, any politicization of Fed decisions would be a problem. At the moment, detailed transcripts of Fed meetings are released with a five-year time lag. Publication of internal Fed deliberations within a year of the bill's passage could compromise the willingness of FOMC participants to take unpopular decisions. The Policy Outlook The reality is that Fed policy will largely be constrained by economic environment, regardless of who is the Chair. A lackluster economic expansion and softer-than-expected wage growth and inflation have supported the maintenance of accommodative policies. But, in the absence of a new downturn, the Fed will stick to its plan of winding down its balance sheet and slowly raising interest rates. If anything, market expectations of a fed funds rate of only 1.5% by the end of 2018 seem too low. Dollar weakness and a strong stock market have meant an easing in overall financial conditions and the fiscal environment is set to become more stimulative. Whoever is leading the Fed next year will be under pressure to communicate a more hawkish stance to the markets. The long-run outlook for monetary policy is a more open question. There will be another recession - possibly as soon as 2019 - and that could be quite a deflationary affair. The next generation of central bankers will have spent more of their formative policy years in an environment when inflation was not a major economic problem and they will have come to terms with the extreme monetary actions needed during the 2007-09 collapse. And with massive quantitative easing failing to deliver the high inflation that many feared, any barriers to even more desperate measures may be limited. Thus, the next downturn may sow the seeds of a return to much higher inflation. Given that demographic trends and a political failure to reign in entitlements will lead to rapidly growing public sector debt, higher inflation would be welcomed by the political establishment. The bottom line is that looming changes in the composition of the Fed's Board of Governors is important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 Yellen's renomination chances may have been undermined by her recent Jackson Hole speech defending the current financial regulatory regime because that puts her at odds with the Administration's desire to unwind some of the Dodd-Frank rules. 2 This table was originally shown in our Special Report "Beware the 2019 Trump Recession", March 7, 2017. 3 There are several variants of the Taylor Rule, depending on smoothing co-efficients and the choice of the real equilibrium rate. We base our estimates on the formula used by the Federal Reserve Bank of Atlanta, with the one change of lowering the real equilibrium rate to 0.5% after 2007. The FRB Atlanta data can be accessed at https://www.frbatlanta.org/cqer/research/taylor-rule.aspx
