The Federal Reserve is a somewhat independent organization from the government which sets monetary policy. In theory, its goal is to be apolitical, however the structure with which it interacts with government makes that problematic. The president appoints Fed governors and the Fed chairperson. Given this structure, it’s difficult for the Federal Reserve not to act politically. Firstly, the president picks candidates who adhere to his ideological vision. With that stated, despite the president playing a role in the appointment process, the Federal Reserve is a private entity that serves the interests of its shareholders, above anyone else. The government, through congress, sets fiscal policies while the privately owned Federal Reserve sets monetary policy. Unless the agenda’s of the two organizations are inline, this could create significant imbalances in the economy.
This situation is particularly interesting in 2017 because the Fed is about to embark on the unwind of its balance sheet. This means it will be allowing the mortgage bonds and treasury bonds to expire instead of rolling them over into new bonds. This situation is interesting by itself, and in the middle of this, Trump will be picking 3 new governors and a new Fed chairperson, making it an uncertain scenario.
It’s important to note that this discussion is aimed at analyzing what the monetary policy is likely to resemble over the next 3.5 years or longer. It’s up to objective investors and economists to determine the direction and next course of action for the Federal Reserve without evoking political bias due to an emotional response supporting or opposing the president.
Candidate Trump criticized chairperson Yellen’s policies by being too interventionist during the campaign. He sounded like Ron Paul, saying the Fed’s low interest rate policy and quantitative easing has propped up this zombie economy. He may have taken up this argument because it was politically expedient. Trump stumbled upon the truth which was deviation from his previous support of low interest rate policies. Trump has tried to have it both ways in some respects because when he was critical of the Fed, he stated his praise of low interest rates while speaking as a real estate developer.
Heading into Trump’s term it was uncertain what he would do with Yellen because he criticized her so heavily. In simplistic terms, you’d think he’d remove her as chairwoman. However, while Trump criticized everyone in the administration it would be impossible to replace everyone at once. If Trump fired Yellen without interviewing candidates for her replacement, it would’ve put the market in turmoil. Therefore, Trump stated he supported Yellen in the beginning of his term. Yellen’s term ends February 3rd, 2018 which is perfect timing because it gave Trump enough to get his footing before having to decide. The top banking regulator appointed by President Obama, Daniel Tarullo resigned in February 2017. It was disheartening for Tarullo to resign as the Fed governor and chairman of the Federal Financial Institutions Examination Council because President Trump has promised to remove the regulations Tarullo spent his career creating.
This brings us to President Trump’s philosophy on monetary policy. The clearest opinion Trump has is his support for deregulation of the banks. That’s a popular conservative position. It’s something Trump has consistently supported. The policy on quantitative easing and interest rates is more complex because the conservative approach appears to be against QE and in favor of a rules based approach to monetary policy, in rhetoric at least, while in practice nothing is being done to advance this cause. A rules based approach would set guidelines for the Fed and would place interest rate policy on autopilot, eliminating uncertainty, while giving the Fed less flexibility. Importantly, the rules based approach would set interest rates higher because the Taylor Rule (an example of a rules based approach) has interest rates higher than the Federal funds rate. The reason why this is complicated and uncertain is because this intense hawkishness could adversely impact the credit based economy, which is struggling to produce GDP above 2% with already low interest rates. Trump will have to balance his rhetoric with reality. Furthermore, it’s important to note that the people who are in favor of deregulation generally are capitalists. There aren’t many people who want to deregulate the banks and love monetary interventionism. It’s a direct ideological inconsistency to favor government intervention and oppose government intervention.
We now have a better idea of who Trump will pick as Fed chair because he has made his selection for two of the three open Governor positions. According to the NY Times, Trump is going with Randal K. Quarles, a member of the Treasury Department in the Bush administration, and Marvin Goodfriend, a former Fed official and an economics professor at Carnegie Mellon University.
Quarles is going to take Tarullo’s spot as the top regulator of the banks. He’s the ideological opposite of Tarullo as he is more favorable to the banks, making deregulation more likely. He believes the financial regulations were made for political reasons opposed regulatory reasons. That’s a good point because regulations are cyclical. After recessions, regulations increase because voters are angry and want action. When the economy is good, regulations are rolled back as the government wants growth to continue. At the end of the cycle, the government will do anything to keep the party going, including eliminating regulations.
Both Quarles and Goodfriend support a rules based approach to monetary policy which means they would be hawks on the FOMC. Their votes could swing the Fed to vote for more rate hikes and could also mean Trump will pick a hawk as Chairperson. Goodfriend has some interesting opinions which are relatively unique among establishment economists. He’s against QE, but favors the idea of the Fed setting interest rates to negative. This is because he feels QE manipulates the market in attempt to get a more dovish policy. It especially affects markets when the central bank buys corporate bonds or stocks. Currently the Fed is one step away from buying stocks. While the Fed is somewhat independent, Republicans would have been irate at that action if it occurred under Obama’s term.
Goodfriend argues negative rates would be a good tool to fight price deflation, which doesn’t need to be fought, unless you think that falling prices are a bad thing?
The policies Goodfriend espouses about negative rates are far from being enacted. Even if Goodfriend was in charge of policy now, he would be raising rates because of the timing of the cycle. Trump still needs to get these picks approved by the Senate and he needs to find a Fed governor pick with community banking experience. The front runner for this position is Robert G. Jones. Finally, he needs to pick a new Fed chairperson. The takeaway from this is that the Fed will likely get more hawkish which means rate hikes and an unwind of QE. The one caveat to this is if the economy continues to decline, the president will be forced to abandon all his rhetoric and focus on continuing the monetary easing from the Obama administration.