President-elect Donald Trump was very critical of the Federal Reserve and its’ Chair, Janet Yellen on the campaign trail. This has led many investors to speculate on the future of several key members at the Fed. While this may make for good TV, the reality is that changes are coming to the Fed which will have important repercussions to investors in the future. I will take a look at the current make-up of the Board of Governors, how the Board will potentially change and what the implications are for monetary policy going forward.
The Federal Reserve typically consists of seven Board of Governors (which includes the Chair, Vice Chair & VC for Supervision) and 12 Presidents of the Federal Reserve Bank Districts. Bank Presidents are appointed by their respective Districts, while the Governors are nominated by the President and confirmed by the Senate. The FOMC, which sets monetary policy, consists of all seven Governors, the President of the NY Fed and four other rotating district Presidents (12 persons in total).
Currently there are two empty seats on the Board of Governors, which the new administration has the authority and ability to fill. There are also three key roles which have the potential to open up when term limits expire. Much speculation has been made about Trump “firing” Yellen and others on the Board once he becomes President. Let’s look at the three seats that are up for nomination over the next two years and if Trump can impact the Fed sooner.
Chair Yellen is designated to serve until February 3rd, 2018. The Federal Reserve Act explicitly states the chair serves out her full term “unless sooner removed for cause by the President.” It would be hard for the President-elect to argue “cause” in removing Chair Yellen, considering how close the Fed is to achieving its dual mandate: low and stable inflation and maximum employment. Advisers to the President have suggested that the administration would not ask Chair Yellen to resign ahead of her term. Yellen could theoretically stay on after her term as Chair expires and keep the Governor seat, but it would be unprecedented (Marriner Eccles’ is the exception).
Vice Chair Fischer
The same “cause” provision also applies to Stanley Fischer, but Fischer’s term expires June 12th 2018. Again, similar to the Chair, it is unusual for the Vice Chair to remain on the board once their term has expired without reappointment.
Vice Chair for Supervision
This is a recently created role in response to the financial crisis and encompasses bank supervision. The seat is currently unfilled, but the responsibilities are being handled by Daniel Tarullo. Since President-elect Trump campaigned on rolling back regulation, we would expect this appointment to be his first priority. He could use one of the two vacant seats to fill this role in relatively short order.
The remaining Board of Governors have terms that are set to expire after 2020. There is speculation that Daniel Tarullo will resign once a Presidential nominee for the Vice Chair for Supervision is appointed since that individual will roll back some of the regulation that Governor Tarullo spent the last five years implementing. So assuming the departure of Governor Tarullo, five out of the seven (including all senior positions) seats of the Board of Governors will likely be new in 2018.
Balancing Appointments vs. Regulatory oversight
The President-elects advisors are “sound money” economists who favor rule-based policies and a majority of which have a monetarist lean. If the Fed’s approach does shift in this direction, it will be a dramatic deviation from their behavior over the last 30 years, and particularly since the global financial crisis. The current Fed regime placed a high degree of importance on the level and changes of asset prices, volatility and other financial variables (often referred to as financial conditions). Following through on a “sound money” policy would represent a material shift in monetary policy regimes, and investor perceptions/behavior will look significantly different than over the last eight years. I would expect structurally higher volatility and a “Fed put” that is further out of the money. What will be unique for policymakers in the short-term is that monetary policy will be accompanied by fiscal policy. This will likely soften the transition of regimes within the Fed.
There are two prominent bills (FORM Act & FRI Act) in Congress which have varying degrees of oversight into the Fed’s policy. While Trump has promised to roll back many regulations, additional oversight on the Fed appear to be a given. The FORM Act is a very strict rules-based initiative designed after John Taylors’ widely known methodology.
Change is coming to the Fed in 2018 and the shift will be toward a more rules-based framework whether by legislation or by leadership. The President will shape whether this is a cyclical shift (committee composition) or a secular shift (legislative). The new administration will need to balance the compositional commitment to “sound money” vs. the call for increased oversight. The scope for change is large with five of seven Board of Governors likely to be new faces in 2018, and hopefully favors compositional shift in policy framework.
The Yellen Fed may in fact mark the end of the three decade long stance in Fed policy that started with Alan Greenspan, in which monetary policy was tailored more toward financial conditions. The Fed’s current sensitivity to market stability may still cause the 2017 FOMC to continue a cautious risk-managed approach to policy. The current Fed recognizes that 2018 will mark a material shift in the way monetary policy operates and may look to offset a more hawkish committee with easier than appropriate policy in the near-term.
I remind myself that the Trump administration has very ambitious goals for his first few years in office and a monetary policy board that is impeding the benefits of hard fought fiscal stimulus seems incongruous. The Fed will look different and changes are afoot, but it is hard to believe they will come at the expense of “Making America Great Again.” Avoid getting caught up in the rumors and watch the nominations. Priorities are important in sending a message. If the President-elect nominates the Vice Chair for Supervision ahead of a replacement for the Chair, that would be a positive sign that a pragmatic approach to a regime shift is underway. The shift towards a rules-based framework is coming under a Trump administration. Recognizing this fact, the better alternative to formalizing a rules-based approach through legislation, is to appoint committee members that believe in the approach but retains the flexibility to use discretion. Regardless, 2018 is likely going to feel a lot different than the past eight years to investors.