Rules Reign on Trump’s Fed List as Post-Crisis Economy Breaks ThemBy
Help wanted: rule-based policy makers with deregulatory tilt
Yellen’s focus on employment fits White House emphasis on jobs
The list President Donald Trump’s aides are compiling to lead the Federal Reserve draws mostly from Republican economics central casting. The candidates prefer a more disciplined approach to monetary policy, view excessive regulation as an obstacle to growth and criticize Fed decisions aimed at problems outside its scope.
The question investors will ask is whether those attributes will help tackle the big challenges in a post-crisis world. Low inflation makes the zero boundary on interest rates that much closer in the next recession. The American work force is aging, testing fiscal limits and leaving monetary policy as one of the main policy levers to throttle growth up or down. The U.S. economy’s growth potential has slumped for several unforeseen reasons, requiring policy makers to be adaptable and open-minded.
“We are sliding toward the next big crisis that we don’t know how to deal with,” said Paul Mortimer-Lee, chief economist for North America at BNP Paribas in New York. “Innovation and the ability to think outside the box, but to do it credibly,” are the attributes needed for the next Fed leader.
Yet Republicans have something of an obsession about curtailing the Fed’s policy discretion. The House of Representatives passed legislation in 2015 and 2017 that would require the Fed to follow a policy rule. Both bills stalled, but they reflect an abiding discomfort among lawmakers toward a public agency having free rein over the cost of credit.
Another Republican criticism, and one that some Fed officials agree with, is that monetary policy can’t solve problems such as weak productivity and skill mismatches in the labor force. The trouble is, fiscal policy paralysis leaves monetary policy as the main policy tool.
Congress and the Fed “are deeply intertwined,” said Mark Spindel, co-author of a new book on the Fed and politics. “You can’t blame the Fed without blaming Congress. I am deeply troubled. The next crisis is going to be even harder.”
That test will fall to whoever is running the Fed after Feb. 3, when the term of the current chair, Janet Yellen, expires. The expansion is in its ninth year and the Fed has only been able to lift its policy rate to a range of 1 percent to 1.25 percent from close to zero. Yellen is betting that gradual policy tightening will reduce slack in the labor market and push prices up over time toward the Fed’s 2 percent target, which it has undershot for most of the past five years.
Financial markets are second-guessing her strategy of patience on inflation. Yields on 10-year Treasuries have declined 0.25 percentage point since the start of the year. Low inflation isn’t a bad thing near term. But missing the target for a long time erodes credibility and it puts the zero interest-rate boundary that much closer in the next downturn.
“Thinking through the transmission of monetary policy to inflation is high on the agenda” for the next Fed regime, said David Stockton, the Fed’s chief economic forecaster under former chairmen Alan Greenspan and Ben Bernanke.
Bloomberg News reported last week that the White House is considering three Ph.D. economists who’ve served in past Republican administrations: John Taylor of Stanford University; Lawrence Lindsey, a former Fed governor and private consultant; and Glenn Hubbard, dean of Columbia University’s business school.
Two bankers are on the list: John Allison, the former chief executive officer of BB&T Corp., and Richard K. Davis, the former chief executive and current executive chairman of US Bancorp. Kevin Warsh, a former Fed governor and visiting fellow at Stanford’s Hoover Institution, is among the contenders, as are Yellen for renomination and White House economic adviser Gary Cohn, a former president of Goldman Sachs Group Inc.
Lindsey, Allison and Davis weren’t available for comment. Yellen, through a spokeswoman, declined to comment, as did Warsh. Taylor and Cohn didn’t respond to requests for comment.
Either through luck or insight, all four past Fed chairs have answered the unique economic challenges of their time, even if each had their blind spots.
Paul Volcker attacked double-digit inflation, at high political and social costs. Greenspan spotted the proliferation of technology and ran a monetary policy that unleashed a record-setting expansion. Bernanke, a Great Depression scholar, responded with creative tools to keep credit flowing in the depths of the 2007-2009 recession. Yellen, a labor specialist, is testing the limits of labor use after a second jobless recovery left millions on the Americans sidelined for years.
The main question surrounding Trump’s candidates is whether they, too, will rise to the challenge of the times.
Taylor is an expert on monetary rules, and has a mathematical formula describing central bank behavior named after him. The Taylor Rule today says the Fed’s policy is on target if one assumes that the longer-run real interest rate keeping supply and demand in balance is zero.
Taylor, Hubbard, Warsh, and John Cogan, who like Warsh is a Hoover Institution fellow, wrote an essay in July saying 3 percent growth is attainable through “significant tax reform, regulatory reform, budget reform and monetary reform.”
Both Taylor and Hubbard, in interviews and writing, show they are willing to be flexible when it comes to monetary rules. The Fed could deviate under special circumstances but should explain why, they’ve argued, and whatever it does should be disciplined enough that its actions are somewhat self-explanatory.
“The Fed needs to have a strategy of maintain and explain -- say what is you are doing and then be transparent about why you are deviating,” Hubbard said in an interview. “The best thing we could do right now is to have a much better fiscal policy. What would take pressure off the Fed is to have a big fiscal tax reform bill.”
Current and former Fed officials have been critical of rules-based policy. William Dudley, the New York Fed President, noted in an interview with the Associated Press in August that the Taylor Rule in September 2008 called for increases in interest rates just after the failure of Lehman Brothers, an event that deepened the financial crisis.
“The notion that truly rule-based of monetary policy is going to lessen the challenges of central banks or make their actions more clear probably isn’t right,” Stockton, who is now a senior fellow at the Peterson Institute for International Economics in Washington. “Quite often you are hit with shocks that a rule isn’t robust enough to deal with.”
Also, a simple monetary policy rule doesn’t seem to answer the strategic challenge of why inflation seems less responsive to monetary policy or even tight labor markets, and what central banks will do to stimulate the economy if they cut rates to zero again. Yellen in 2016 said forward guidance and asset purchases would again be the tools to overcome the zero boundary. She warned, however, that they might not be adequate.
Two of the people White House officials are looking at have banking experience and aren’t economists.
Allison was the chief executive officer at BB&T Corp., a regional bank, for nearly two decades. He would be an unusual choice for the chairmanship because he is skeptical about the need for a central bank. He told CNBC in February that if he had a “magic wand, I wouldn’t have a Federal Reserve. I would have a private banking system.”
It’s not publicly known what Davis, who worked for Minneapolis-based US Bancorp, thinks about dealing with the zero boundary on interest rates.
Few of the attributes seen in Republican candidates can be found in Yellen. She has resisted legislation that would bind monetary policy to a rule. Yellen’s speech in Jackson Hole, Wyoming, last month was open to modest changes in financial rules, not a sweeping overhaul.
Despite the bad fit with Republican dogmas, Yellen’s commitment to keeping the economy at full employment is one attribute that Trump will notice, analysts said.
“If there is one thing the White House is sensitive to, it is job creation,” said Ed Al-Hussainy, a senior analyst on Columbia Threadneedle Investment’s global rates and currency team. “The lowest-hanging fruit is to have Janet Yellen reappointed.”
— With assistance by Matthew Boesler