CHIEF INVESTMENT OFFICE Investment Insights AUGUST 2017 Matthew Diczok A Focus on the Fed Head of Fixed Income Strategy An Overview of the Federal Reserve System and a Look at Potential Personnel Changes SUMMARY After years of accommodative policy, the Federal Reserve (Fed) is on its path to policy normalization. The Fed forecasts another rate hike in late 2017, and three hikes in each of the next two years. The Fed also plans to taper reinvestments of Treasurys and mortgage-backed securities, gradually reducing its balance sheet. The market thinks differently. Emboldened by inflation persistently below target, it expects the Fed to move significantly more slowly, with only one to three rate hikes between now and early 2019. One way or another, this discrepancy will be reconciled, with important implications for asset prices and yields. Against this backdrop, changes in personnel at the Fed are very important, and have been underappreciated by markets. The Fed has three open board seats, and the Chair and Vice Chair are both up for reappointment in 2018. If the administration appoints a Fed Chair and Vice Chair who are not currently governors, then there will be five new, permanent voting members who determine rate moves—almost half of the 12-member committee. This would be unprecedented in the modern era. Similar to its potential influence on the Supreme Court, this administration has the ability to set the tone of monetary policy for many years into the future. Most rumored candidates share philosophical leanings at odds with the current board; they are generally hawkish relative to current policy, favor rules-based decision-making over discretionary, and are unconvinced that successive rounds of quantitative easing were beneficial. Given the leanings of these potential candidates, it is entirely possible that the administration instead will choose as Fed Chair a businessperson without formal economic training. While appointing a pro-business, flexible moderate may be better aligned with the administration’s agenda, appointing a non-economist—the first chosen in forty years—may be a concern for the markets. In this piece, we cover: • the Fed’s responsibilities and organizational structure; • key current issues affecting monetary policy; and • potential candidates for Fed vacancies and their likely impact. Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), a registered broker-dealer and Member SIPC, and other subsidiaries of Bank of America Corporation (BofA Corp.). Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value © 2017 Bank of America Corporation. All rights reserved. Overview of the Federal Reserve System1 Twelve Federal Reserve Banks The Fed is the U.S. central bank responsible for both monetary The twelve regional Federal Reserve Banks act as the policy and financial stability. It is tasked by Congress with a operating arms of the Fed. Each Reserve Bank operates within “dual mandate” – maximum employment and stable prices. The its own “district” to gather local economic intelligence to help Fed has three key entities: improve the Fed’s decision-making. The districts are Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, • Federal Reserve Board of Governors; St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. • 12 Federal Reserve Banks; and The Federal Reserve Open Market Committee • Federal Reserve Open Market Committee. The Federal Reserve Open Market Committee (FOMC) sets See Exhibit 1 for a summary of the Fed’s structure. monetary policy, controlling the supply and cost of money to achieve its economic objectives. It uses the Federal Funds rate Federal Reserve Board of Governors as its main policy tool. The FOMC has twelve voting members The Board is the Fed’s governing body, responsible for when fully staffed: guiding the bank’s operations. It has seven members, called • The Board of Governors (seven members, but currently only “Governors.” Each is nominated by the President and confirmed four due to vacancies); by the Senate to a single term of 14 years. The Chair and Vice Chair are appointed and confirmed to a term of four years, • The President of the Federal Reserve Bank of New York but can be reappointed and must either be existing board (currently William Dudley); and members or simultaneously appointed to the board. There are • Four out of 11 non-New York Reserve Bank Presidents on a currently three board vacancies. one-year, rotating basis. Chair Janet Yellen’s first term as Fed Chair ends February 3, By tradition, the FOMC elects the Chair of the Board of 2018. Vice Chair Stanley Fischer’s first term ends on June 12, Governors as Chair of the FOMC, and President of the Federal 2018. Both are eligible for reappointment. In theory, the Chair Reserve Bank of New York to be Vice Chair of the FOMC. or Vice Chair can stay on as Governor, although this rarely While only the 12 FOMC members actually vote, all 12 Reserve occurs in practice. Bank presidents participate in FOMC meetings. (The New York Fed is the only regional bank with a permanent vote.) Exhibit 1: Structure of the Fed Board of Govenors (7) FOMC (12) Federal Reserve Banks (12) 1. Janet Yellen (Chair)* Board of Governors 1. New York 2. Stanley Fischer (Vice Chair)* 1. Janet Yellen (Chair)* 2. Boston 3. Jerome Powell 2. Stanley Fischer* 3. Philadelphia 4. Lael Brainard 3. Jerome Powell 4. Cleveland 5. Open 4. Lael Brainard 5. Richmond 6. Open 5. Open 6. Atlanta 7. Open 6. Open 7. Chicago 7. Open 8. St. Louis Bank of NY President 9. Minneapolis 8. William Dudley (Vice Chair) 10. Kansas City 11. Dallas Four of the 11 non-NY Bank Presidents (One-year rotation as voting FOMC member) 12. San Francisco 9. Chicago (Charles Evans) 10. Dallas (Robert Kaplan) 11. Philadelphia (Patrick Harker) 12. Minneapolis (Neel Kashkari) Source: Federal Reserve and Chief Investment Office. * = eligible for reappointment. 1 Information of the Federal Reserve from www.federalreserve.gov/ CIO REPORTS • Investment Insights 2 CIO REPORTS • Investment Insights CIO REPORTS •Investment not hike as anticipated. not hikeasanticipated. willlikely theFed willcontinuetobe, andthattherefore, years, for five concerned thatsub-trendinflationhasbeenpersistent 2%target.Themarketis theFed’s gradually increasetowards itwill – inflationisalaggingindicatorandbelieves seesthisdisinflationastransitory interpretations. TheFed differing this discrepancy(Exhibit2),andtherearetwo beginning of2019.Thetrendininflationbestillustrates onlyonemore hikewilloccurthroughthe and believes chance ofanotherhikein2017atapproximately50percent, isskepticalandcurrentlyputsthe The market,however, in both2018and2019. Fundstargetrateoncemorein2017,andthreetimes the Fed TheFOMCanticipatesraising balance sheetstartingthisyear. timesandexpectstoshrinkits Fundstargetratefour Fed –inDecember2015.Ithasraisedthe less accommodative –becoming The FOMCstartedtheprocessof“normalization” July 19. from $750billioninDecember2007to$4.2trillion,asof securitiesholdings easing,”increasingtheFed’s “quantitative toas amounts ofsecuritiesinprogramscolloquiallyreferred hasalsopurchased significant TheFed years. seven there for to0%-0.25%inDecember2008, andleft rate waslowered Funds theFed accommodative; Monetary policyhasbeenvery theFOMC Current IssuesFacing Source: BloombergasofJuly17,2017. Inflation (%) andMarkets theFed to aDisconnectBetween Exhibit 2: 0.0 0 1.0 1 2.0 2 3.0 . 5 5 5 2/1/2006 8/1/2006 2/1/2007 8/1/2007 Views onDisinflationareLeading Differing 2/1/2008 Core CPI 8/1/2008 2/1/2009 Fed target 8/1/2009 2/1/2010 8/1/2010 2/1/2011 8/1/2011 2/1/2012 8/1/2012 2/1/2013 8/1/2013 Core PCE 2/1/2014 8/1/2014 2/1/2015 8/1/2015 2/1/2016 8/1/2016 2/1/2017 those moreinclinedtowait. as higher ratessoonerinthecurrentenvironment,anddoves describehawks asparticipantsmorelikelytofavor informally would leanings dependingontheparticularsituation.We hawkishordovish conditions, andasinglemembermayhave anysetofinitial the correctcourseofmonetarypolicyfor thereisaspectrumofbeliefs – islessrelevant.Inreality, inflationgenerally lower withhawks favoring employment, for higher willingtotradehigherinflation divide –doves a statedinflationtarget(2%),sotheclassicalhawk-dove has now (Exhibit 3),butthosetermsareambiguous.TheFed or“hawks” FOMC membersareoftencharacterizedas“doves” ChangestotheBoardofGovernors Potential compositiontochangemoregradually. the Fed’s expect allthevacanciestobefilledinshortorderandexpects itmayalsobethatthemarketdoesnot may becomplacency, The marketdoesnotseemtoregisterthisrisk;while monetary policyandultimatelythetrajectoryofeconomy. of greatlyinfluencethestance confirmation –cantherefore almost halfthecommittee.ThePresident–withSenate’s voting members on theFOMC, newpermanent total offive a could changein2018.Thisissignificant;therebe Chair hasthreeopenvacanciesandtheChairVice Fed thefactthat of assetclassreturns.Thisisexacerbatedby willbeanimportant driver thesedisparateviewsresolve How of the other two openings. of theothertwo one hasbeenreportedtobeacandidatefor June ofthisyear, seats. MarvinGoodfriend,firstmentionedinthebeginning of for anyofthethreeopenboard is theonlyconfirmednominee filled.He legislationbutnever Dodd-Frank position createdby ChairofBankSupervision,a Quarles willbenominatedasVice The WhiteHouseconfirmedonJuly10,2017,thatRandal Governors Fed Potential 3 Exhibit 3: FOMC Members - Characterization of Doves and Hawks Powell Governors Brainard Yellen Fischer