Federal Reserve Uncertainties: Waiting for Names

In congressional testimony February 14 and 15, Federal Reserve Board Chair Janet Yellen signaled a hike in the federal funds rate is very much on the table in March. The Dow Jones Industrial average rose 92 points on the 14^th, and another 107 points on the 15^th. Has the world turned completely upside down? Don’t stock markets know they’re supposed to go down when the Fed threatens a rate hike? What gives?

What happened is Chair Yellen did what the markets expected, and in so doing she eliminated a element of policy uncertainty. This uncertainty had been priced into the market as a discount. Uncertainty eliminated, discount disappeared, markets rose.

Uncertainty is the bread and butter of financial markets. Understanding uncertainties and managing risk is central to what market participants do and how they make, or lose, money. However, uncertainty regarding policies relevant to markets and the economy is nearly always harmful. Janet Yellen eliminated a policy uncertainty. The markets rallied. This lesson regarding policy uncertainty is likely to come into play again in the coming months in another respect involving the Federal Reserve, specifically, the question who is going to serve on the board and who is going to lead it.

President Trump will have an extraordinary ability to recast the Federal Reserve Board by naming at least four and as many as six governors.

The issue of the Fed’s leadership does not garner much attention currently, perhaps because so many other issues and events vie for attention: The new administration, repealing and replacing and reforming Obamacare, revoking Obama administration executive orders and writing new ones, the possibility of comprehensive tax reform, discerning the true trade policies of the new administration, etc., etc. All these seem more immediate, however none will prove more important to U.S. economic performance during President Trump’s term of office than the choice of who will lead the Fed.

The issue arises because the two open seats at the Fed will soon be joined by a third when Governor Tarullo steps down in early April. The issue sharpens further when one notes Janet Yellen’s term as Fed Chair concludes at the end of January, 2018. Vice Chairman Stanley Fischer’s term expires just five months later.

President Trump could ask Yellen to accept another four-year term, but this seems highly unlikely as every President likes to put his (or her) stamp on the Fed’s leadership. Further, if Yellen is not re-nominated, then she will almost certainly resign her seat, meaning a fourth Fed governorship will need to be filled. The same could be true of Fischer with respect to his Vice Chairmanship and his governor’s position. Further, it would not surprise if at least one of the remaining two governors also took their leave in this period.

What this all means is that President Trump will have an extraordinary ability to recast the Federal Reserve Board by naming at least four and as many as six governors. It also means Trump has an extraordinary opportunity, and challenge, to identify his pick to be Yellen’s successor. Ideally, this pick would be among the three governors nominated early in 2017, thus allowing Yellen’s heir apparent some time on the board prior to assuming the chairmanship.

To be very clear, the Federal Reserve Board Chairman is one of the most powerful economic policy leaders in the United States and indeed in the world. Every central bank makes mistakes in the conduct of monetary policy. Over the next few years the Fed, led by the new chairman will make mistakes. The key is to make only little mistakes, mistakes the economy can overcome, mistakes the Fed itself can correct without too much trouble. Little mistakes are irritating; big mistakes can cost millions of jobs. The choice of Fed Chair will suggest whether the Fed’s future mistakes are big ones or little ones.

As 2017 unfolds, market participants will increasingly focus on who Trump might nominate for all three governorships, but especially the one suggested as Chair Yellen’s successor. Because of the enormity of the risks of getting this pick wrong, the resulting uncertainty could grow to become a drag on business confidence. The pick of chair-apparent doesn’t have to be brilliant. It does have to be solid. It’s a very difficult job for which very few are truly qualified.

President Trump will enjoy a second major opportunity to put his stamp on the Fed’s policymaking in nominating two vice chairs, one succeeding Stanley Fischer if he departs, and a second in the Vice Chair for Supervision. This position, created by Dodd-Frank, has been left vacant ever since. President Obama could have nominated one of the other sitting governors for this position, but chose not to do so.

When President Trump puts forward names for the three open governor seats, one should clearly be intended as Janet Yellen’s successor in 2018, and one should simultaneously be named as the Vice Chair for Supervision, assuming the position immediately upon confirmation. Through Dodd-Frank the Federal Reserve was given enormous new responsibilities for regulating and supervising the financial system. The new vice chair was to provide operational leadership, and accountability, to these activities.

Rarely, if ever, has a president enjoyed such an opportunity to recast the Federal Reserve Board so completely in such a short period. His choices will have enormous import for financial markets and the economy more broadly. If President Trump leaves these matters untended for long, the markets will notice, uncertainty will build, and market values and business investment in particular could suffer. President Trump has nominated many fine people to serve in his government. His upcoming Fed choices need to be among his best.

About the authors

J.D. Foster

Dr. J.D. Foster is the former senior vice president, Economic Policy Division, and former chief economist at the U.S. Chamber of Commerce. He explores and explains developments in the U.S. and global economies.