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Page Traditionally, the Selection of the Next Chairperson Of Volume 84 October 2017 Traditionally, the selection of the next Chairperson of the Federal Reserve is anything but a compelling drama or anything worth paying particular attention to. To the contrary, the identity of the nominee is normally a foregone conclusion as, since World War II, every Chairperson who completed a first term has been nominated for a second term. In an environment of such clarity, many investors have largely ignored the nomination process, as the presumed nominee is well-discounted by the markets well in advance of the actual nomination. There is virtually no drama or suspense. However, the current nomination process has been anything but normal, and there are a number of significant reasons why this particular appointment could have longer-term, game-changing ramifications. The first reason is that President Trump is looking increasingly likely to bring in a new Federal Reserve Chair at a critically important time in our history. That is not to downplay in any way the extraordinary challenges faced by Chairman Bernanke, who used unconventional and largely experimental monetary tools to rescue the global economy from a replay of the Great Depression, or Chairwoman Yellen who has so deftly started normalizing interest rates and prepared the markets for the ultimate unwinding of the Fed’s multi-trillion-dollar quantitative easing stimulus programs. The presumed new Fed Chair is going to be responsible for not only carrying forward their predecessor’s policy of higher interest rates, but also oversee the domestic and global economies, as the world’s various central bankers slowly drain much of the excess monetary liquidity which has supported and helped to drive higher this historic reflation in financial assets (stocks, bonds and real estate). This is without precedent, as the world has never before seen such a massive, global and pro-active shrinkage of the world’s money supply. From our perspective, it is a less-than- ideal time to change jockeys, particularly when the current jockey, Janet Yellen is almost certainly the most qualified person on earth to do the job. 1 | Page Despite the fact that Yellen is a Democrat nominated by President Obama, President Trump himself has acknowledged the superior job that she has done. As he recently put it, “She was very impressive. I liked her a lot. I mean, it’s somebody that I am thinking about.” But, he continued, “I have to say you’d like to make your own mark.” This comment is hardly surprising given how important absolute loyalty is to the President. Moreover, the presumed replacement of Yellen would not necessarily be such a terrible thing, if one was confident that she would be replaced by someone with comparable insight, experience and expertise. Unfortunately though, one cannot make that assumption, as some of the candidates reportedly on President Trump’s short list to lead the Federal Reserve have the potential to be very detrimental to the economy and the financial markets. Whoever is ultimately selected to fill the top position at the Fed already has an uphill battle even under the best of circumstances, as investors are currently pricing in a future path for monetary policy that is far more dovish (i.e., investors expect rates to stay lower and for longer) than what has been detailed in current Fed guidance. Current market expectations, as illustrated by futures prices, are for a likely third 2017 rate hike in December, but only one more rate hike in 2018 (a total of four hikes over the two- year period: the yellow line), which is much less aggressive than the seven rate increases that the Fed is telling investors to expect over the period. This suggests to us that short-term, market-set rates will likely need to move higher regardless of the new Fed chair, and that they might be forced to move higher rapidly, if candidates like Warsh or Taylor were to move into positions of influence. Also noteworthy is the unconventional way in which the President is making his selection. To explain, a president normally decides what attributes they want in the leader of the Fed, and then goes about selecting between candidates that share those same attributes and philosophy about monetary policy. In contrast, President Trump has reportedly assembled a short list of candidates that represent almost every conceivable view on monetary policy and Fed operations, ranging from Jay Powell, who is viewed as a Republican version of Janet Yellen, to Kevin Warsh and John Taylor, who have been among the Fed’s loudest critics, and who want to dramatically reform the structure and operations of America’s central bank. Each would also be expected to significantly accelerate both the trend towards higher rates and the rate of shrinkage of the Fed’s quantitative easing stimulus. 2 | Page The Chairperson of the Fed is in a very powerful position, and can usually control the monetary policy discussion. However, they do not act alone, which might normally provide some comfort that, even in the event that President Trump nominates a fairly radical reformist (who would also need to be approved by the Senate), they would be effectively constrained by the other board members. However, with Vice-Chairman Stanley Fischer retiring in November, and Chairwoman Yellen’s first term ending in February of next year, President Trump will get to nominate at least three more candidates to the Fed Board of Governors. Since he has already appointed one governor, Randal Quarles, it means that President Trump will get to appoint at least four of the seven members of the Fed Board of Governors. Of the two existing governors not being considered for Chairperson, one, Mr. Quarles, favors major reform of the Fed and a faster unwinding of the quantitative easing programs, and one, Lael Brainard, is a more traditional Fed governor who favors continuing the current “slow and steady” unwinding of the Fed’s historic stimulus programs. Everyone expects that Janet Yellen, who has always been considered a fairly dovish voice, will leave the Fed if not reappointed as Chairwoman, which would cost the Fed one of its biggest advocates for continued Fed independence, and one of the strongest proponents of a slow and steady normalization of monetary policy. When fully staffed, the seven members of the Federal Reserve Board account for the majority of the twelve members that vote on monetary policy. The other five votes come from Presidents of the various Regional Federal Reserve Banks. The bottom line is that President Trump has an opportunity to reshape the Federal Reserve to an extent that could change the outlook for monetary policy and how it is determined for years, if not decades, which is why it is so important that he get this right. In fact, he needs to get it right multiple times, as each of these appointments is of such critical importance. One other consideration that might be of particular interest to investors is how the Fed will, under new leadership, react to the potential passage of a big fiscal stimulus/tax package out of Washington, D.C., particularly when it is being proposed at the worst possible time in the business cycle, when the Federal Reserve is already tightening monetary policy to keep the economy from running too hot and creating an inflation problem. Granted, the United States badly needs tax reform, albeit something much more substantial than what is being proposed, and we understand that, as a politician, you need to take what you can get, when you have the votes to get it. 3 | Page However, by introducing a large fiscal stimulus program near the end of one of the longest economic expansions in history, it simply creates an environment where the Federal Reserve will likely be forced to become more and more restrictive on monetary policy, with the purpose of offsetting the inflationary risks caused by the fiscal stimulus. This is a lesson that President Reagan learned in 1981, when the Fed sharply raised rates to offset the stimulative effects of the big Reagan tax reform plan. This is of critical importance, because the proposed tax package is estimated to balloon the deficit by $1.5 trillion unless it proves to be so stimulative to the economy that tax revenues will increase sufficiently to offset all of the revenues that were given up as part of tax reform. The problem is that the Fed is very unlikely to allow that to happen at a time when the economy is already running so close to full capacity, and the Fed is worried about the prospects for future inflation. Since monetary policy normally overwhelms fiscal policy, the most likely outcome may turn out to be lower taxes, but a bigger national debt, a flatter yield curve (which reduces liquidity in the financial system) and a slower economy. It would be like a company borrowing money just so that it can increase its dividend. It provides some instant gratification, but is normally quite detrimental over the longer term. Further, unless the tax cuts can avoid increasing the deficit, they must, by law, be only temporary, which suggests that they would likely not be very stimulative, even if the Fed decides not take steps to offset them. To explain, according to Milton Friedman's Permanent Income Hypothesis, consumers only spend money that is gained through a source considered to be permanent (like a raise), and tend to instead just save any additional money gained from a temporary source (like a rebate or temporary tax cut). Ironically, the above scenario of a potential monetary policy offset to fiscal stimulus (i.e.
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