What a Trump-Branded Federal Reserve Might Look Like
The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
President-elect Donald Trump has the opportunity to remake the Federal Reserve.
Or does he? And if he does, what would it look like?
Trump has opinions on monetary policy – and they resemble many of his other opinions in that they are flexible. Early in his campaign he praised a low interest rate environment. Later, he accused Federal Reserve Chair Janet Yellen of holding interest rates low to help support President Barack Obama and in the process create a "false" economy. Despite this mix of praise and criticism, Trump Economic Advisor Judy Shelton, claims that his administration will respect the Fed's independence.
Given Trump's mixed messages, speculation on the future Fed is just that, speculation. Still, begin with what we know. Trump can nominate two governors to fill open positions on the Fed Board immediately. Yellen's position as chair expires Feb. 3, 2018. Trump previously stated he would replace her with a Republican. That would be a third spot.
Or would it? Technically, Yellen's spot on the Board does not expire until 2024. While it would be expected that she vacated the board when she vacates the chair, it is not required (and indeed former Fed Chair Marriner Eccles remained on the board after his chairmanship expired). Yellen could stay on as a thorn in the administration’s side.
In the financial community, questions are being asked about how long Vice Chair Stanley Fischer nor Governor Daniel Tarullo will stay on. The election of Trump could affect their calculus, prompting them to remain until their terms end, in 2020 and 2022, respectively. Governors Lael Brainard and Jerome Powell can hold their seats until 2026 and 2028, respectively. Brainard, obviously, will not be headed to the U.S. Treasury as some had speculated she might under a win by Democratic Nominee Hillary Clinton.
In other words, fears that Trump would be able to remake the board immediately are premature. Indeed, the Fed is structured to prevent just such an occurrence. We forget this because turnover has been high in recent years. But it could slow dramatically, especially if current board members remain to protect the institution's independence. Trump's two nominees, one of which may become chair in 2018, would not by themselves form a significant voting bloc even if so inclined to pursue a dramatically different policy than the current Fed.
Under this path, the Fed retains much of it current identity with the possible change of dissents shifting from regional presidents to board members. One could even imagine the chair as one of the dissenters (Eccles was also the last chair to cast a dissenting vote). But overall the Fed's reaction function, and hence the expected policy path, would remain familiar to market participants.
There are two possible branches from this path. One is that the Fed continues to follow policies consistent with "best practices" in central banking and the administration respects its independence. This is the best of all outcomes.
But a darker branch could emanate from this path. Consider the possibility that the administration becomes enraged that they cannot remake the Fed. This may be the case, for instance, if the Fed deems it necessary to offset impending fiscal stimulus and the inflation it might bring with higher interest rates. Some Fed officials already see room for higher rates in a Republican-controlled government.
The administration, aided by a friendly U.S. Congress, might in this case pursue legislative options to bring the Fed more in control of the executive branch, thereby curtailing the Fed's independence. The central bank was made by congress, and can be unmade by congress. Indeed, the Fed will almost certainly face additional efforts to rein in its independence via a revival of "Audit the Fed" bills in any event. In the worst case scenario, the Fed as we know it could become a completely different organization that does not adhere to central banking best practices.
But what policies would such a Fed pursue? Consider the path that Trump does get to remake the Fed by either taking advantage of upcoming resignations of Board members or in the medium term by legislative action. Typically, we would think such an outcome would be inflationary. If the administration fears a monetary offset, it would pick pliable board members who are willing to hold rates low, thereby allowing the Fed to overshoot its current mandates. The future might then look like the 1970s.
Yet another direction is possible. The "Audit the Fed" movement generally believes monetary policy remains too loose. For example, the suggestion of forced application of a Taylor Rule, or even just requiring the Fed to explain deviations from the Taylor Rule, are a reaction to the persistently low interest rate policies pursued in the post-Great Recession world. If the administration continues to pursue this logic, it may be that a Trump Fed would be a so-called "hard money" Fed.
There are two potential challenges with a "hard money" Fed. The first is that it would remove financial accommodation too quickly. This does not seem likely in the near term; it would take until 2018 at the earliest until the Fed could be remade either through attrition or legislation.
The second challenge, however, is more disconcerting. Trump's characterization of the current economy as "false" suggests a sympathy for the Austrian school of economics, in which short-term monetary benefits are believed to come with longer-run costs. The "false" economy fosters asset price bubbles that pop and end in an even deeper recession than would otherwise be the case.
A Fed packed with Austrian economists would likely react slowly to a recession and resist extraordinary policies such as quantitative easing. They would also likely attempt to tighten policy soon after the recession ended. They would, in other words, tend toward a liquidationist approach that risks turning the Great Recession into another Great Depression.
Finally, note that regulatory policy — not monetary policy — faces more immediate impacts from the new administration. One of Trump's nominees would most likely serve in the currently vacant position of vice chair for supervision. This would give Trump the ability to exert influence on the regulatory environment facing the financial industry. That the nominee will likely possess a business-friendly attitude.
Bottom Line: There are three possible directions for monetary policy. The best outcome would be continuity, or a Fed that remains independent and follows current best practices supported by personnel chosen for their expertise. Alternatively, the Fed— either through personnel attrition or legislation — becomes politicized. That path leads to either a loose money Fed or a hard money Fed. The former sets the stage for inflation, the latter, deep, long, and painful liquidationist recessions. My expectation would be the former. In any case, Trump's first marks will be felt on regulatory rather than monetary policy.