CHIEF INVESTMENT OFFICE Investment Insights

AUGUST 2017

Matthew Diczok A Focus on the Fed Head of Fixed Income Strategy An Overview of the 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 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 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-—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 (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, , Philadelphia, Cleveland, Richmond, Atlanta, Chicago, • Federal Reserve Board of Governors; St. Louis, Minneapolis, Kansas City, Dallas, and . • 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 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 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 ’s first term as Fed Chair ends February 3, By tradition, the FOMC elects the Chair of the Board of 2018. Vice Chair ’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. 2. Stanley Fischer* 3. Philadelphia 4. 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 ()

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 Current Issues Facing the FOMC How these disparate views resolve will be an important driver Monetary policy has been very accommodative; the Fed Funds of asset class returns. This is exacerbated by the fact that the rate was lowered to 0%-0.25% in December 2008, and left Fed has three open vacancies and the Chair and Vice Chair there for seven years. The Fed has also purchased significant could change in 2018. This is significant; there could be a amounts of securities in programs colloquially referred to as total of five new permanent voting members on the FOMC, “quantitative easing,” increasing the Fed’s securities holdings almost half the committee. The President – with the Senate’s from $750 billion in December 2007 to $4.2 trillion, as of confirmation – can therefore greatly influence the stance of July 19. monetary policy and ultimately the trajectory of the economy. The market does not seem to register this risk; while this The FOMC started the process of “normalization” – becoming may be complacency, it may also be that the market does not less accommodative – in December 2015. It has raised the expect all the vacancies to be filled in short order and expects Fed Funds target rate four times and expects to shrink its the Fed’s composition to change more gradually. balance sheet starting this year. The FOMC anticipates raising the Fed Funds target rate once more in 2017, and three times Potential Changes to the Board of Governors in both 2018 and 2019. FOMC members are often characterized as “doves” or “hawks” (Exhibit 3), but those terms are ambiguous. The Fed now has The market, however, is skeptical and currently puts the a stated inflation target (2%), so the classical hawk-dove chance of another hike in 2017 at approximately 50 percent, divide – doves willing to trade higher inflation for higher and believes only one more hike will occur through the employment, with hawks favoring lower inflation generally beginning of 2019. The trend in inflation best illustrates – is less relevant. In reality, there is a spectrum of beliefs of this discrepancy (Exhibit 2), and there are two differing the correct course of monetary policy for any set of initial interpretations. The Fed sees this disinflation as transitory conditions, and a single member may have hawkish or dovish – inflation is a lagging indicator – and believes it will leanings depending on the particular situation. We would gradually increase towards the Fed’s 2% target. The market is informally describe hawks as participants more likely to favor concerned that sub-trend inflation has been persistent for five higher rates sooner in the current environment, and doves as years, will continue to be, and that therefore, the Fed will likely those more inclined to wait. not hike as anticipated. Potential Fed Governors Exhibit 2: Differing Views on Disinflation are Leading The White House confirmed on July 10, 2017, that Randal to a Disconnect Between the Fed and Markets Quarles will be nominated as Vice Chair of Bank Supervision, a position created by Dodd-Frank legislation but never filled. He 3.0 Fed target is the only confirmed nominee for any of the three open board 2.5 seats. Marvin Goodfriend, first mentioned in the beginning of 2.0 June of this year, has been reported to be a candidate for one 1.5 of the other two openings.

Inflation (%) 1.0

0.5

0.0 2 / 1 0 6 8 / 1 2 0 6 2 / 1 0 7 8 / 1 2 0 7 2 / 1 0 8 8 / 1 2 0 2 / 1 0 9 8 / 1 2 0 9 2 / 1 0 8 / 1 2 0 2 / 1 0 8 / 1 2 0 2 / 1 0 8 / 1 2 0 2 / 1 0 3 8 / 1 2 0 3 2 / 1 0 4 8 / 1 2 0 4 2 / 1 0 5 8 / 1 2 0 5 2 / 1 0 6 8 / 1 2 0 6 2 / 1 0 7 Core CPI Core PCE

Source: Bloomberg as of July 17, 2017.

CIO REPORTS • Investment Insights 3 Exhibit 3: FOMC Members - Characterization of Doves and Hawks

Powell Governors Brainard Yellen Fischer Dovish Hawkish Dudley* 2017 Voters Kashkari Evans Kaplan Harker Regional Fed 2018 Voters Bostic Williams Mester (Richmond)** Presidents

2019 Voters Bullard Evans Rosengren George

Source: Bank of America Merrill Lynch Global Research as of July 14, 2017. * N.Y. Fed President is always a voter. ** Richmond Fed President (Lacker) stepped down abruptly; there is no replacement at this time.

Randal Quarles: Quarles is a former high-ranking Treasury rule-based, and therefore increased transparency can only official in the George W. Bush administration. He is thought to lead to market confusion. In his opinion, without a rules- be in consonance with the administration’s deregulatory and based policy framework, market participants think less about simplification agenda. In several 2015 interviews2,3, Quarles economic developments and more about how current FOMC characterized Dodd-Frank as being “not aggressive enough” members think and act; “it’s a crazy way to run a railroad for and partially designed for political rather than financial/ the Federal Reserve.” regulatory reasons. He opined that it allowed the government Marvin Goodfriend: Goodfriend is an Professor to be too much of a “player” in the financial sector, when at Carnegie Mellon, and former director of research at the instead, it “should be a referee.” He believes that the Federal Reserve Bank of Richmond. He is an oft-cited author government-sponsored enterprises (e.g. Fannnie Mae, Freddie on . While we would agree with the Mac) do not need to exist. characterization of Goodfriend as hawkish in the current He co-authored an op-ed4 arguing that while the regulatory environment, that does not describe any dogmatic bias. He has focus on large banks was “politically appealing,” it was a implied that the Fed is currently behind the curve and there is red herring that drew attention away from more important a systematic reason that this is historically the case. He holds sources of systemic risk. Furthermore, higher capital that the Fed needs to be equally concerned with inflation requirements increase the cost of credit and come at the being too low or too high relative to its target, and thinks expense of economic and income growth. We characterize that while the Fed has established credibility against inflation, Quarles as moderately hawkish. He seems decidedly less it has yet to establish credibility against deflation. It can be lenient with discretionary, qualitative monetary policy-making assumed he considers a low inflation target to have some by the FOMC. He has described increased transparency as elemental risk, as it puts one close to the “zero lower bound,” one of Bernanke’s “signal accomplishments” but postulated which can constrain policy in a deflationary environment. that, as opposed to the Fed’s intent, this actually increased Intriguingly, he posits a number of non-conventional ways uncertainty in the markets. He clarified that transparency that negative interest rates could be transmitted through itself is welcome; the problem arises because the Fed is not the economy5, which are unorthodox and very different

2 Quarles interview #1 www.bloomberg.com/news/videos/2015-05-06/bernanke-using-powers-for-good-at-pimco-randy-quarles 3 Quarles interview #2 www.bloomberg.com/news/videos/2015-11-20/does-it-matter-if-the-fed-raises-rates-in-dec- 4 Quarles op-ed www.wsj.com/articles/focusing-on-bank-size-missing-the-real-problem-1459466136 5 Goodfriend on negative rates www.kansascityfed.org/~/media/files/publicat/sympos/2016/econsymposium-goodfriend-paper.pdf

CIO REPORTS • Investment Insights 4 from current Fed practice. Goodfriend also believes that comment during the Fed’s recent press conference, Yellen the inflation target should be formalized and approved by deftly answered by implying her stance as being situationally Congress, not just the Fed – which only announced in 2012 dependent, and very much the appropriate course of action that it believed that inflation of 2% was “most consistent over during the recent period of economic weakness. While as the longer run” with its statutory mandate. (While the Federal a candidate Trump was critical of the Fed, in office the Reserve Reform Act does specify “stable prices” as a goal, that administration has not criticized the Chair at all. It is entirely term is never defined.) possible that she will be reappointed, but that is not base case.

Goodfriend is otherwise very conservative in his central The process for considering a potential successor to Yellen banking philosophy, feeling that interest-rate moves are the is reportedly being managed by Gary Cohn, the former most effective policy tool. He would likely advocate to limit president of Goldman Sachs and President Trump’s economic any future quantitative easing to Treasury securities. He advisor. Three candidates are often mentioned as potential believes that non-Treasury purchases are credit allocation replacements. Interestingly, all three seem to – on balance – and a surrogate form of fiscal policy, and if the Fed (as prefer tighter monetary policy currently, which is the case for opposed to Congress) starts affecting fiscal policy, its political the two rumored Governors as well: independence will be threatened, which he views as critical. • John Taylor, a distinguished research economist currently at He has stated that a departure from a Treasurys-only policy Stanford University should be occasional, only as a “lender of last resort” to sound banks, and anything beyond that should only be implemented • Glenn Hubbard, another distinguished economist and Dean of with the express agreement of fiscal authorities. This might Columbia Business School mean that he would favor a more rapid reduction of Mortgage • Kevin Warsh, a former Governor of the Federal Reserve Backed Securities on the Fed’s balance sheet than currently Board, currently at Stanford anticipated. He seems to favor more quick and pre-emptive However, it is important to note that this list is not exhaustive measures to fight inflation before it arrives – he wrote and is based only on press reports; the Fed chair may likely positively of the pre-emptive rate hike cycles of 1994, before be someone outside of this list, or outside of academic inflation risks were obvious – as he thinks that current policy completely. Based on past appointments in the leads to the Fed being chronically late. He has said that the administration, a financial executive with more business “Federal Reserve is a little bit behind the curve in raising experience who is more in tune with the White House’s rates,”6 a sentiment he echoed in March,7 – “over 100 years objectives may be viewed as a more suitable candidate. of Federal Reserve history… almost all the time the Federal The President recently confirmed that Cohn, who is heading Reserve gets caught behind the curve.” Like Quarles, he favors the search, is a potential candidate for the job.12,13. Cohn is a more rules-based approach.8,9,10 considered more lenient in terms of regulation and balanced- Potential Fed Chairs to-dovish in terms of rate hikes. As mentioned, Chair Yellen’s term expires in February and John Taylor: Taylor is a Professor of Economics at Stanford, she is eligible for reappointment, and most expect her to with expertise in , monetary economics, retire from the Board if not reappointed. According to the and international economics. He has extensive government Wall Street Journal, President Trump told her that she was experience, being on the President’s Council of Economic doing a good job, and that “he considered her, like himself, Advisers, a member of the Congressional Budget Office’s Panel 11 a ‘low-interest-rate’ person.” When asked about this of Economic Advisers, and an Undersecretary of Treasury

6 Bloomberg article re: Fed candidates: www.bloomberg.com/news/articles/2017-01-08/potential-fed-chairs-suggest-they-would-pursue-tighter-policy 7 www.bloomberg.com/news/videos/2017-03-03/the-taylor-rule-hope-springs-eternal 8 Goodfriend Congress testimony on price stability www.financialservices.house.gov/uploadedfiles/hhrg-115-ba19-wstate-mgoodfriend-20170316.pdf 9 Goodfriend paper on monetary lessons www.shadowfed.org/wp-content/uploads/2015/10/GoodfriendSOMC-October2015.pdf 10 Goodfriend Congress testimony on Fed credit allocation www.financialservices.house.gov/uploadedfiles/hhrg-113-ba19-wstate-mgoodfriend-20140312.pdf 11 Trump v Yellen www.wsj.com/articles/beneath-the-uneasy-peace-between-donald-trump-and-janet-yellen-1497346203 12 www.politico.com/story/2017/07/11/trump-cohn-yellen-fed-240421 13 www.wsj.com/articles/trump-says-cohn-and-yellen-are-contenders-to-lead-the-fed-1501011815

CIO REPORTS • Investment Insights 5 for International Affairs.14 Taylor is a long-tenured, extremely stagnation, but thinks slower growth is due to a “deviation well-respected economist with both the policy chops and the from first principles” of what causes economies to prosper. He Washington political experience to be a Fed Chair. He is well- posits four types of necessary reform – tax, regulatory, budget known for the so-called “,” an explicit, quantitative and monetary. Regarding the Fed, he expressly said that strategy to inform central bank monetary policy. The Taylor “personnel” change is necessary and the “too-low-for-too-long rule (Exhibit 4) takes three variables – inflation versus a target, rates in 2003-2005” were “largely” a direct cause of the crisis, the economy’s distance from its potential, and the short-term a different view from former Chair . He views rate necessary to maintain full employment – to prescribe a current low rates and reach-for-yield concerning, and thinks recommended inflation-adjusted policy rate, although Taylor that “unorthodox” quantitative easing has “been a problem.” He does not advocate following a rule mechanically. Versions of it believes the Fed should formally enunciate and report on its have been used by multiple central banks; most outputs of the strategy, and detail whenever it deviates from it.16 Taylor rule would have seen significantly higher rates than the Glenn Hubbard: Hubbard is also a well-respected economist Fed actually followed since the financial crisis. with significant government experience. He is the Dean of Columbia Business School, a former high-ranking official at the Exhibit 4: Baseline Taylor Rules vs. Fed Funds U.S. Treasury, and Chair of the Council of Economic Advisors. Target Rate He is often mentioned as a potential Fed chair, and was 9 purported to be the runner-up when Ben Bernanke was first 7 appointed as Fed chair in 2006. As a PhD-trained economist 5 he – like Taylor – fits the mold as a mainstream . 3

1 Hubbard favors a classical, modest approach to central

-1 banking, aware of its limits, especially without concurrent Fed Funds Rate (%) -3 government fiscal policy. At the same panel with Taylor, he

-5 was positive about the Fed’s initial response to the financial crisis but thought that it had continued a policy that was

Mar 00 Mar 01 Mar 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15 Mar 16 Mar 17 “past its prime,” and seemed more skeptical of successive Rate Implied by Taylor Rule Actual Fed Funds Rate rounds of quantitative easing. He strongly believes a central bank’s key role is to be a lender of last resort emphasizing Source: Bloomberg as of July 17, 2017. both transparency and flexibility, and is critical of Dodd-Frank in this regard. He is expected to be moderately deregulatory; While Taylor has spoken positively about the Fed’s response he worries that the post-crisis reforms have put policies to the financial crisis, he has been expressly critical of in place to avoid the next crisis, but may limit the Fed’s its discretionary policy-making in general and its specific flexibility to deal with the next one. The focus on individual actions after the crisis: “a serious financial crisis, a very capital requirements has ignored the more important focus deep recession, a not-so-great recovery, and now a virtually on potential contagion, as even healthy institutions can strategy-free international monetary system … this is not a get caught up in a panic, so individual bank supervision good record”15. At a conference in January, he argued that is necessary but not sufficient to forestall or deal with the biggest issue facing us currently – sub-trend economic future crises. growth – is not in spite of recent fiscal and monetary policies but actually caused by them. He does not believe in secular

14 Taylor bio: www.johnbtaylor.com/ 15 www.wsj.com/articles/taylor-on-bernanke-monetary-rules-work-better-than-constrained-discretion-1430607377 16 Taylor / Hubbard panel www.aeaweb.org/webcasts/2017/president.php

CIO REPORTS • Investment Insights 6 Hubbard thinks fiscal policy is necessary to confront the recent conduct of monetary policy “deeply flawed,” the Fed’s growth dilemma, and estimates that tax reform could raise economic models “troublingly unreliable”; he argued for focus growth by 0.50% per year, or 2.75% annually for the next on short-term data results in “erratic policy lurches,” and 10 years. He expects Fed normalization to continue, and believes the Fed is overly concerned with financial markets18. potentially proceed at a quicker rate if fiscal policy was Some may be concerned about his lack of economics enacted in a short time period.17 training, which would be a concern for any Chair that is not an economist. Given his current role as fellow at Stanford’s Kevin Warsh: Warsh is a former Fed Governor who has a law Hoover Institute, he has close policy ties to John Taylor. degree, worked in investment banking, and was the youngest Fed Governor on record. Given his business experience, Conclusion Warsh served as a Fed liaison to the corporate and financial The Fed could have five or more new permanent voting sector. Traditionally, the Governors are selected in part for members as early as 2018. In an era where central banks their ability to enhance policy discussions with their own have been a (if not “the”) key driver of market returns, the risk direct experiences; for example, Brainard’s experience with of this transition has been underappreciated, in our opinion. the international sector and Powell’s experience with private Importantly, the rumored slate of candidates tends to be – sector finance. Coming with a lawyer’s perspective and not an on balance – more hawkish than the current board, critical economist’s, as Chair (or Vice Chair) he would be a departure of many recent Fed policies, and dismissive of qualitative, from standard practice, and the first non-economist in four discretionary central bank decision-making in general. Finally, decades. It has been done before, and given the Cohn rumors there is a reasonable chance that a new Fed chair will not be and the administration’s preference for experienced business a trained economist and is instead chosen from the business professionals, it is not a given that the next Fed Chair be an sector, which has not occurred in over 40 years and may be of economist. Most Fed watchers anticipate that Warsh would concern to the markets. These issues are not at the forefront be an advocate for a light regulatory touch, higher rates, and of the market currently, but investors should be attuned to more weight to a rules-based approach to setting monetary the dynamics and expect to see more headlines on this as we policy. In a Wall Street Journal op-ed in 2016, he called the move into the back end of 2017.

17 Taylor / Hubbard panel www.aeaweb.org/webcasts/2017/president.php 18 www.wsj.com/articles/the-federal-reserve-needs-new-thinking-1472076212

CIO REPORTS • Investment Insights 7 CHIEF INVESTMENT OFFICE Christopher Hyzy Chief Investment Officer Bank of America Global Wealth & Investment Management

Mary Ann Bartels Karin Kimbrough Niladri Mukherjee Head of Merrill Lynch Wealth Head of Investment Strategy Director of Portfolio Strategy, Management Portfolio Strategy Merrill Lynch Wealth Management Private Banking & Investment Group (PBIG) and International Nicholas Giorgi Emmanuel D. Hatzakis Marci McGregor Rodrigo C. Serrano John Veit Vice President Director Director Vice President Director

Investing involves risk, including the possible loss of principal. The views and opinions expressed are subject to change without notice at any time, and may differ from views expressed by Merrill Lynch or any of its affiliates. These views are provided for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. This material was prepared by the Global Wealth & Investment Management Chief Investment Office (GWIM CIO) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the GWIM Chief Investment Office only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions. © 2017 Bank of America Corporation . All rights reserved. ARY8YR4G