Idea Transcript
CHIEF INVESTMENT OFFICE
Investment Insights AUGUST 2017
Matthew Diczok Head of Fixed Income Strategy
A Focus on the Fed
An Overview of the Federal Reserve System and a Look at Potential Personnel Changes
SUMMARY After years of accommodative policy, the Federal Reserve (Fed) is on its path to policy normalization. The Fed forecasts another rate hike in late 2017, and three hikes in each of the next two years. The Fed also plans to taper reinvestments of Treasurys and mortgage-backed securities, gradually reducing its balance sheet. The market thinks differently. Emboldened by inflation persistently below target, it expects the Fed to move significantly more slowly, with only one to three rate hikes between now and early 2019. One way or another, this discrepancy will be reconciled, with important implications for asset prices and yields. Against this backdrop, changes in personnel at the Fed are very important, and have been underappreciated by markets. The Fed has three open board seats, and the Chair and Vice Chair are both up for reappointment in 2018. If the administration appoints a Fed Chair and Vice Chair who are not currently governors, then there will be five new, permanent voting members who determine rate moves—almost half of the 12-member committee. This would be unprecedented in the modern era. Similar to its potential influence on the Supreme Court, this administration has the ability to set the tone of monetary policy for many years into the future. Most rumored candidates share philosophical leanings at odds with the current board; they are generally hawkish relative to current policy, favor rules-based decision-making over discretionary, and are unconvinced that successive rounds of quantitative easing were beneficial. Given the leanings of these potential candidates, it is entirely possible that the administration instead will choose as Fed Chair a businessperson without formal economic training. While appointing a pro-business, flexible moderate may be better aligned with the administration’s agenda, appointing a non-economist—the first chosen in forty years—may be a concern for the markets. In this piece, we cover: • the Fed’s responsibilities and organizational structure; • key current issues affecting monetary policy; and • potential candidates for Fed vacancies and their likely impact.
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Overview of the Federal Reserve System1
Twelve Federal Reserve Banks
The Fed is the U.S. central bank responsible for both monetary policy and financial stability. It is tasked by Congress with a “dual mandate” – maximum employment and stable prices. The Fed has three key entities:
The twelve regional Federal Reserve Banks act as the operating arms of the Fed. Each Reserve Bank operates within its own “district” to gather local economic intelligence to help improve the Fed’s decision-making. The districts are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
• Federal Reserve Board of Governors; • 12 Federal Reserve Banks; and
The Federal Reserve Open Market Committee
• Federal Reserve Open Market Committee. See Exhibit 1 for a summary of the Fed’s structure. Federal Reserve Board of Governors The Board is the Fed’s governing body, responsible for guiding the bank’s operations. It has seven members, called “Governors.” Each is nominated by the President and confirmed by the Senate to a single term of 14 years. The Chair and Vice Chair are appointed and confirmed to a term of four years, but can be reappointed and must either be existing board members or simultaneously appointed to the board. There are currently three board vacancies. Chair Janet Yellen’s first term as Fed Chair ends February 3, 2018. Vice Chair Stanley Fischer’s first term ends on June 12, 2018. Both are eligible for reappointment. In theory, the Chair or Vice Chair can stay on as Governor, although this rarely occurs in practice.
The Federal Reserve Open Market Committee (FOMC) sets monetary policy, controlling the supply and cost of money to achieve its economic objectives. It uses the Federal Funds rate as its main policy tool. The FOMC has twelve voting members when fully staffed: • The Board of Governors (seven members, but currently only four due to vacancies); • The President of the Federal Reserve Bank of New York (currently William Dudley); and • Four out of 11 non-New York Reserve Bank Presidents on a one-year, rotating basis. By tradition, the FOMC elects the Chair of the Board of Governors as Chair of the FOMC, and President of the Federal Reserve Bank of New York to be Vice Chair of the FOMC. While only the 12 FOMC members actually vote, all 12 Reserve Bank presidents participate in FOMC meetings. (The New York Fed is the only regional bank with a permanent vote.)
Exhibit 1: Structure of the Fed FOMC (12)
Board of Govenors (7) 1. Janet Yellen (Chair)* 2. Stanley Fischer (Vice Chair)* 3. Jerome Powell 4. Lael Brainard 5. Open 6. Open 7. Open
Federal Reserve Banks (12)
Board of Governors 1. Janet Yellen (Chair)* 2. Stanley Fischer*
1. New York 2. Boston 3. Philadelphia
3. Jerome Powell 4. Lael Brainard 5. Open 6. Open 7. Open
4. Cleveland 5. Richmond 6. Atlanta 7. Chicago 8. St. Louis 9. Minneapolis 10. Kansas City 11. Dallas 12. San Francisco
Bank of NY President 8. William Dudley (Vice Chair) Four of the 11 non-NY Bank Presidents (One-year rotation as voting FOMC member) 9. Chicago (Charles Evans) 10. Dallas (Robert Kaplan) 11. Philadelphia (Patrick Harker) 12. Minneapolis (Neel Kashkari) Source: Federal Reserve and Chief Investment Office. * = eligible for reappointment. 1
Information of the Federal Reserve from www.federalreserve.gov/
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Current Issues Facing the FOMC Monetary policy has been very accommodative; the Fed Funds rate was lowered to 0%-0.25% in December 2008, and left there for seven years. The Fed has also purchased significant amounts of securities in programs colloquially referred to as “quantitative easing,” increasing the Fed’s securities holdings from $750 billion in December 2007 to $4.2 trillion, as of July 19. The FOMC started the process of “normalization” – becoming less accommodative – in December 2015. It has raised the Fed Funds target rate four times and expects to shrink its balance sheet starting this year. The FOMC anticipates raising the Fed Funds target rate once more in 2017, and three times in both 2018 and 2019. The market, however, is skeptical and currently puts the chance of another hike in 2017 at approximately 50 percent, and believes only one more hike will occur through the beginning of 2019. The trend in inflation best illustrates this discrepancy (Exhibit 2), and there are two differing interpretations. The Fed sees this disinflation as transitory – inflation is a lagging indicator – and believes it will gradually increase towards the Fed’s 2% target. The market is concerned that sub-trend inflation has been persistent for five years, will continue to be, and that therefore, the Fed will likely not hike as anticipated.
How these disparate views resolve will be an important driver of asset class returns. This is exacerbated by the fact that the Fed has three open vacancies and the Chair and Vice Chair could change in 2018. This is significant; there could be a total of five new permanent voting members on the FOMC, almost half the committee. The President – with the Senate’s confirmation – can therefore greatly influence the stance of monetary policy and ultimately the trajectory of the economy. The market does not seem to register this risk; while this may be complacency, it may also be that the market does not expect all the vacancies to be filled in short order and expects the Fed’s composition to change more gradually.
Potential Changes to the Board of Governors FOMC members are often characterized as “doves” or “hawks” (Exhibit 3), but those terms are ambiguous. The Fed now has a stated inflation target (2%), so the classical hawk-dove divide – doves willing to trade higher inflation for higher employment, with hawks favoring lower inflation generally – is less relevant. In reality, there is a spectrum of beliefs of the correct course of monetary policy for any set of initial conditions, and a single member may have hawkish or dovish leanings depending on the particular situation. We would informally describe hawks as participants more likely to favor higher rates sooner in the current environment, and doves as those more inclined to wait.
Potential Fed Governors Exhibit 2: Differing Views on Disinflation are Leading to a Disconnect Between the Fed and Markets 3.0
Fed target
Inflation (%)
2.5 2.0 1.5
The White House confirmed on July 10, 2017, that Randal Quarles will be nominated as Vice Chair of Bank Supervision, a position created by Dodd-Frank legislation but never filled. He is the only confirmed nominee for any of the three open board seats. Marvin Goodfriend, first mentioned in the beginning of June of this year, has been reported to be a candidate for one of the other two openings.
1.0 0.5
2/1/2006 8/1/2006 2/1/2007 8/1/2007 2/1/2008 8/1/2008 2/1/2009 8/1/2009 2/1/2010 8/1/2010 2/1/2011 8/1/2011 2/1/2012 8/1/2012 2/1/2013 8/1/2013 2/1/2014 8/1/2014 2/1/2015 8/1/2015 2/1/2016 8/1/2016 2/1/2017
0.0
Core CPI
Core PCE
Source: Bloomberg as of July 17, 2017.
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Exhibit 3: FOMC Members - Characterization of Doves and Hawks
Brainard
Powell Yellen
Kashkari
Dudley* Kaplan
Dovish 2017 Voters 2018 Voters 2019 Voters
Evans Bostic
Bullard
Governors Fischer Hawkish Harker Williams
Evans
Mester
Regional Fed Presidents
(Richmond)**
Rosengren
George
Source: Bank of America Merrill Lynch Global Research as of July 14, 2017. * N.Y. Fed President is always a voter. ** Richmond Fed President (Lacker) stepped down abruptly; there is no replacement at this time.
Randal Quarles: Quarles is a former high-ranking Treasury official in the George W. Bush administration. He is thought to be in consonance with the administration’s deregulatory and simplification agenda. In several 2015 interviews2,3, Quarles characterized Dodd-Frank as being “not aggressive enough” and partially designed for political rather than financial/ regulatory reasons. He opined that it allowed the government to be too much of a “player” in the financial sector, when instead, it “should be a referee.” He believes that the government-sponsored enterprises (e.g. Fannnie Mae, Freddie Mac) do not need to exist. He co-authored an op-ed4 arguing that while the regulatory focus on large banks was “politically appealing,” it was a red herring that drew attention away from more important sources of systemic risk. Furthermore, higher capital requirements increase the cost of credit and come at the expense of economic and income growth. We characterize Quarles as moderately hawkish. He seems decidedly less lenient with discretionary, qualitative monetary policy-making by the FOMC. He has described increased transparency as one of Bernanke’s “signal accomplishments” but postulated that, as opposed to the Fed’s intent, this actually increased uncertainty in the markets. He clarified that transparency itself is welcome; the problem arises because the Fed is not
rule-based, and therefore increased transparency can only lead to market confusion. In his opinion, without a rulesbased policy framework, market participants think less about economic developments and more about how current FOMC members think and act; “it’s a crazy way to run a railroad for the Federal Reserve.” Marvin Goodfriend: Goodfriend is an Economics Professor at Carnegie Mellon, and former director of research at the Federal Reserve Bank of Richmond. He is an oft-cited author on monetary economics. While we would agree with the characterization of Goodfriend as hawkish in the current environment, that does not describe any dogmatic bias. He has implied that the Fed is currently behind the curve and there is a systematic reason that this is historically the case. He holds that the Fed needs to be equally concerned with inflation being too low or too high relative to its target, and thinks that while the Fed has established credibility against inflation, it has yet to establish credibility against deflation. It can be assumed he considers a low inflation target to have some elemental risk, as it puts one close to the “zero lower bound,” which can constrain policy in a deflationary environment. Intriguingly, he posits a number of non-conventional ways that negative interest rates could be transmitted through the economy5, which are unorthodox and very different
Quarles interview #1 www.bloomberg.com/news/videos/2015-05-06/bernanke-using-powers-for-good-at-pimco-randy-quarles Quarles interview #2 www.bloomberg.com/news/videos/2015-11-20/does-it-matter-if-the-fed-raises-rates-in-dec 4 Quarles op-ed www.wsj.com/articles/focusing-on-bank-size-missing-the-real-problem-1459466136 5 Goodfriend on negative rates www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-goodfriend-paper.pdf 2 3
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from current Fed practice. Goodfriend also believes that the inflation target should be formalized and approved by Congress, not just the Fed – which only announced in 2012 that it believed that inflation of 2% was “most consistent over the longer run” with its statutory mandate. (While the Federal Reserve Reform Act does specify “stable prices” as a goal, that term is never defined.)
comment during the Fed’s recent press conference, Yellen deftly answered by implying her stance as being situationally dependent, and very much the appropriate course of action during the recent period of economic weakness. While as a candidate Trump was critical of the Fed, in office the administration has not criticized the Chair at all. It is entirely possible that she will be reappointed, but that is not base case.
Goodfriend is otherwise very conservative in his central banking philosophy, feeling that interest-rate moves are the most effective policy tool. He would likely advocate to limit any future quantitative easing to Treasury securities. He believes that non-Treasury purchases are credit allocation and a surrogate form of fiscal policy, and if the Fed (as opposed to Congress) starts affecting fiscal policy, its political independence will be threatened, which he views as critical. He has stated that a departure from a Treasurys-only policy should be occasional, only as a “lender of last resort” to sound banks, and anything beyond that should only be implemented with the express agreement of fiscal authorities. This might mean that he would favor a more rapid reduction of Mortgage Backed Securities on the Fed’s balance sheet than currently anticipated. He seems to favor more quick and pre-emptive measures to fight inflation before it arrives – he wrote positively of the pre-emptive rate hike cycles of 1994, before inflation risks were obvious – as he thinks that current policy leads to the Fed being chronically late. He has said that the “Federal Reserve is a little bit behind the curve in raising rates,”6 a sentiment he echoed in March,7 – “over 100 years of Federal Reserve history… almost all the time the Federal Reserve gets caught behind the curve.” Like Quarles, he favors a more rules-based approach.8,9,10
The process for considering a potential successor to Yellen is reportedly being managed by Gary Cohn, the former president of Goldman Sachs and President Trump’s economic advisor. Three candidates are often mentioned as potential replacements. Interestingly, all three seem to – on balance – prefer tighter monetary policy currently, which is the case for the two rumored Governors as well: • John Taylor, a distinguished research economist currently at Stanford University • Glenn Hubbard, another distinguished economist and Dean of Columbia Business School • Kevin Warsh, a former Governor of the Federal Reserve Board, currently at Stanford
Potential Fed Chairs
However, it is important to note that this list is not exhaustive and is based only on press reports; the Fed chair may likely be someone outside of this list, or outside of academic economists completely. Based on past appointments in the administration, a financial executive with more business experience who is more in tune with the White House’s objectives may be viewed as a more suitable candidate. The President recently confirmed that Cohn, who is heading the search, is a potential candidate for the job.12,13. Cohn is considered more lenient in terms of regulation and balancedto-dovish in terms of rate hikes.
As mentioned, Chair Yellen’s term expires in February and she is eligible for reappointment, and most expect her to retire from the Board if not reappointed. According to the Wall Street Journal, President Trump told her that she was doing a good job, and that “he considered her, like himself, a ‘low-interest-rate’ person.”11 When asked about this
John Taylor: Taylor is a Professor of Economics at Stanford, with expertise in macroeconomics, monetary economics, and international economics. He has extensive government experience, being on the President’s Council of Economic Advisers, a member of the Congressional Budget Office’s Panel of Economic Advisers, and an Undersecretary of Treasury
Bloomberg article re: Fed candidates: www.bloomberg.com/news/articles/2017-01-08/potential-fed-chairs-suggest-they-would-pursue-tighter-policy www.bloomberg.com/news/videos/2017-03-03/the-taylor-rule-hope-springs-eternal 8 Goodfriend Congress testimony on price stability www.financialservices.house.gov/uploadedfiles/hhrg-115-ba19-wstate-mgoodfriend-20170316.pdf 9 Goodfriend paper on monetary lessons www.shadowfed.org/wp-content/uploads/2015/10/GoodfriendSOMC-October2015.pdf 10 Goodfriend Congress testimony on Fed credit allocation www.financialservices.house.gov/uploadedfiles/hhrg-113-ba19-wstate-mgoodfriend-20140312.pdf 11 Trump v Yellen www.wsj.com/articles/beneath-the-uneasy-peace-between-donald-trump-and-janet-yellen-1497346203 12 www.politico.com/story/2017/07/11/trump-cohn-yellen-fed-240421 13 www.wsj.com/articles/trump-says-cohn-and-yellen-are-contenders-to-lead-the-fed-1501011815 6 7
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for International Affairs.14 Taylor is a long-tenured, extremely well-respected economist with both the policy chops and the Washington political experience to be a Fed Chair. He is wellknown for the so-called “Taylor Rule,” an explicit, quantitative strategy to inform central bank monetary policy. The Taylor rule (Exhibit 4) takes three variables – inflation versus a target, the economy’s distance from its potential, and the short-term rate necessary to maintain full employment – to prescribe a recommended inflation-adjusted policy rate, although Taylor does not advocate following a rule mechanically. Versions of it have been used by multiple central banks; most outputs of the Taylor rule would have seen significantly higher rates than the Fed actually followed since the financial crisis. Exhibit 4: Baseline Taylor Rules vs. Fed Funds Target Rate 9
Fed Funds Rate (%)
7 5 3
stagnation, but thinks slower growth is due to a “deviation from first principles” of what causes economies to prosper. He posits four types of necessary reform – tax, regulatory, budget and monetary. Regarding the Fed, he expressly said that “personnel” change is necessary and the “too-low-for-too-long rates in 2003-2005” were “largely” a direct cause of the crisis, a different view from former Chair Ben Bernanke. He views current low rates and reach-for-yield concerning, and thinks that “unorthodox” quantitative easing has “been a problem.” He believes the Fed should formally enunciate and report on its strategy, and detail whenever it deviates from it.16 Glenn Hubbard: Hubbard is also a well-respected economist with significant government experience. He is the Dean of Columbia Business School, a former high-ranking official at the U.S. Treasury, and Chair of the Council of Economic Advisors. He is often mentioned as a potential Fed chair, and was purported to be the runner-up when Ben Bernanke was first appointed as Fed chair in 2006. As a PhD-trained economist he – like Taylor – fits the mold as a mainstream choice. Hubbard favors a classical, modest approach to central
1 -1 -3
Rate Implied by Taylor Rule
Mar 17
Mar 16
Mar 15
Mar 14
Mar 13
Mar 12
Mar 11
Mar 10
Mar 09
Mar 08
Mar 07
Mar 06
Mar 05
Mar 04
Mar 03
Mar 02
Mar 01
Mar 00
-5
Actual Fed Funds Rate
Source: Bloomberg as of July 17, 2017.
While Taylor has spoken positively about the Fed’s response to the financial crisis, he has been expressly critical of its discretionary policy-making in general and its specific actions after the crisis: “a serious financial crisis, a very deep recession, a not-so-great recovery, and now a virtually strategy-free international monetary system … this is not a good record”15. At a conference in January, he argued that the biggest issue facing us currently – sub-trend economic growth – is not in spite of recent fiscal and monetary policies but actually caused by them. He does not believe in secular
banking, aware of its limits, especially without concurrent government fiscal policy. At the same panel with Taylor, he was positive about the Fed’s initial response to the financial crisis but thought that it had continued a policy that was “past its prime,” and seemed more skeptical of successive rounds of quantitative easing. He strongly believes a central bank’s key role is to be a lender of last resort emphasizing both transparency and flexibility, and is critical of Dodd-Frank in this regard. He is expected to be moderately deregulatory; he worries that the post-crisis reforms have put policies in place to avoid the next crisis, but may limit the Fed’s flexibility to deal with the next one. The focus on individual capital requirements has ignored the more important focus on potential contagion, as even healthy institutions can get caught up in a panic, so individual bank supervision is necessary but not sufficient to forestall or deal with future crises.
Taylor bio: www.johnbtaylor.com/ www.wsj.com/articles/taylor-on-bernanke-monetary-rules-work-better-than-constrained-discretion-1430607377 16 Taylor / Hubbard panel www.aeaweb.org/webcasts/2017/president.php 14 15
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Hubbard thinks fiscal policy is necessary to confront the growth dilemma, and estimates that tax reform could raise growth by 0.50% per year, or 2.75% annually for the next 10 years. He expects Fed normalization to continue, and potentially proceed at a quicker rate if fiscal policy was enacted in a short time period.17 Kevin Warsh: Warsh is a former Fed Governor who has a law degree, worked in investment banking, and was the youngest Fed Governor on record. Given his business experience, Warsh served as a Fed liaison to the corporate and financial sector. Traditionally, the Governors are selected in part for their ability to enhance policy discussions with their own direct experiences; for example, Brainard’s experience with the international sector and Powell’s experience with private sector finance. Coming with a lawyer’s perspective and not an economist’s, as Chair (or Vice Chair) he would be a departure from standard practice, and the first non-economist in four decades. It has been done before, and given the Cohn rumors and the administration’s preference for experienced business professionals, it is not a given that the next Fed Chair be an economist. Most Fed watchers anticipate that Warsh would be an advocate for a light regulatory touch, higher rates, and more weight to a rules-based approach to setting monetary policy. In a Wall Street Journal op-ed in 2016, he called the
17 18
recent conduct of monetary policy “deeply flawed,” the Fed’s economic models “troublingly unreliable”; he argued for focus on short-term data results in “erratic policy lurches,” and believes the Fed is overly concerned with financial markets18. Some may be concerned about his lack of economics training, which would be a concern for any Chair that is not an economist. Given his current role as fellow at Stanford’s Hoover Institute, he has close policy ties to John Taylor.
Conclusion The Fed could have five or more new permanent voting members as early as 2018. In an era where central banks have been a (if not “the”) key driver of market returns, the risk of this transition has been underappreciated, in our opinion. Importantly, the rumored slate of candidates tends to be – on balance – more hawkish than the current board, critical of many recent Fed policies, and dismissive of qualitative, discretionary central bank decision-making in general. Finally, there is a reasonable chance that a new Fed chair will not be a trained economist and is instead chosen from the business sector, which has not occurred in over 40 years and may be of concern to the markets. These issues are not at the forefront of the market currently, but investors should be attuned to the dynamics and expect to see more headlines on this as we move into the back end of 2017.
Taylor / Hubbard panel www.aeaweb.org/webcasts/2017/president.php www.wsj.com/articles/the-federal-reserve-needs-new-thinking-1472076212
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