The Perils of a Trumped Fed
The US Federal Reserve has spent decades establishing its credibility as an apolitical guarantor of growth and stability. But now that US President Donald Trump has a chance to pack the Fed Board with his own appointees, the institution's tradition of careful, dispassionate economic stewardship could come to a sudden end.
ITHACA – While he attempts to overhaul American tax, trade, and immigration policies, President Donald Trump is mulling over a set of decisions that could prove even more consequential for the US economy. With Federal Reserve Vice Chair Stanley Fischer having retired this month, three of the seven seats on the Fed Board of Governors are now vacant. And in February 2018, Fed Chair Janet Yellen’s first term will end, giving Trump a unique opportunity to stamp his brand on the institution.
Trump’s nominees to fill these positions, and how he goes about choosing them, could have an enduring impact not just on the Fed, but also on the US economy and its central position in the global financial system.
The Fed’s credibility has been methodically and painstakingly established over the course of many decades. A case in point is former Fed Chair Paul Volcker’s decision, in the early 1980s, to hike interest rates and accept a temporary increase in unemployment. Had Volcker not acted, the US would have suffered from spiraling inflation. Volcker’s move induced the short-term pain; but it also bolstered the Fed’s long-term credibility.
Inflation is driven by many factors that the Fed cannot control, including productivity, foreign prices, and government deficits. But expectations about the future can also play a key role. When firms and workers think the Fed is not committed to holding down inflation, inflation tends to rise.
The same is true for deflation. At first blush, falling prices for goods and services may sound like a good thing. But deflation can be disastrous. When prices are expected to fall, consumers will hold off on making purchases, and businesses will postpone investments. These decisions can then create a vicious cycle in which falling demand leads to reduced employment, growth, and prices, causing demand to fall further.
After the 2008 global financial crisis, many countries faced the specter of deflation. But, thanks to the Fed, the US avoided both severe deflation and inflation, and recovered faster than most other advanced economies. The Fed managed to ward off deflation in the US by aggressively loosening monetary policy. At the time, many economists feared that a rapidly expanding money supply and sharply rising government debt would fuel inflation and weaken the dollar. But these fears proved unfounded, and the Fed’s credibility was bolstered once again.
The Fed’s credibility is what underpins the US dollar’s dominance in international finance. About two-thirds of global central banks’ foreign-exchange reserves – that is to say, their rainy-day funds – are invested in dollars. And foreign investors, including central banks, hold more than $6 trillion in US government securities, up from $3 trillion a decade ago. The dollar’s status as the main global reserve currency has helped to keep US interest rates low, thus reducing borrowing costs for US consumers and the US government.
The Fed’s independence, along with the US’s institutionalized system of checks and balances and its adherence to the rule of law, is crucial for sustaining investors’ confidence in the dollar. Yet the Trump administration is weakening the checks and balances between the executive and legislative branches of government, and his indifference to the rule of law could pose a direct challenge to the judicial branch. Under these circumstances, any act that undermines the Fed’s independence could seriously damage the institutional framework upon which US economic strength rests.
The Fed has international credibility precisely because it is independent from any political master. But the Fed also has legitimacy, because it is accountable to the government and to the people. That accountability is, or at least should be, based on pre-established economic targets – namely, low inflation and unemployment – rather than on the political whims of whoever is in power at a given moment.
From this perspective, Trump could seriously damage the Fed’s credibility. He need only appoint political loyalists instead of the best available technocrats; or appoint competent technocrats whom he has cajoled into professing personal loyalty to him, rather than to their mandates as Fed governors.
A Fed dominated by Trump acolytes might prioritize economic growth over other objectives, such as maintaining financial stability and low inflation. But while this approach may boost GDP growth for a brief period, it would hurt growth in the long run, by fueling inflation and financial-market instability.
Another danger is that Trump will get his wish for a weaker dollar – permanently. Even the mere possibility of reduced faith in the dollar, alongside higher inflation, could push up interest rates, leading to larger budget deficits, lower growth, and an inflationary spiral.
If Trump does try to press the Fed into the service of his own political agenda, he could do irreparable harm to an institution that ensures financial stability, low and stable inflation, and sustainable growth. Rather than putting “America first,” he would be undercutting the dollar’s status as the dominant global reserve currency, and clearing the way for others to fill its role in global financial markets.
The Next Fed Chair
Good central bankers make decisions based on what they believe is best for the economy, relying on evolving data, not on evolving political imperatives. Only two of the Trump administration's five apparent candidates to chair the US Federal Reserve fit the bill.
CAMBRIDGE – US President Donald Trump’s administration is expected, by November 2, to announce its choice, subject to Senate approval, to succeed Janet Yellen as Chair of the Federal Reserve Board in February 2018. The White House has indicated that it is weighing five potential candidates. Not all of them would be a good choice.
The first candidate is Yellen herself. Though Yellen is a Democrat originally appointed by President Barack Obama, there is strong precedent for Trump to re-appoint her. Her three predecessors – Ben Bernanke, Alan Greenspan, and Paul Volcker – were each re-appointed to second terms by a president of the opposite party from the one who first appointed them, reflecting the value of continuity and predictability in central banking.
Yellen, whom I have known since we worked together in 1977, has performed very well in her nearly four years as Fed Chair. Though she hasn’t confronted a crisis, she did help to sustain the US economy’s steady recovery from the 2007-09 recession. Yellen, like Bernanke before her, used the Fed’s tools with a combination of clear communication and policy flexibility, shifting course as data revealed subtle changes in economic conditions.
The results speak for themselves. When Yellen was appointed to the Fed Board as Vice Chair in 2010, the US unemployment rate was at 9.9%. By the time she was promoted to Chair in 2014, it had fallen to 6.7%. Today, it stands at just 4.2% – and yet inflation remains low. Some complain that inflation remains below the 2% target; but the combination of low unemployment and low inflation used to be viewed as macroeconomic Nirvana.
The second potential candidate for Fed Chair is Jerome Powell, who has been on the Fed Board for five years. Powell might represent a good compromise for policymakers. On one hand, he has supported Yellen’s strategy, from her dovish interest-rate policies to her recent moves toward normalization. On the other, he is a longtime Republican with a financial background.
But Powell might face skepticism for his lack of academic training as an economist. PhD economists, like those who dominate the Fed’s staff and leadership, tend to favor their own kind and doubt others’ qualifications for top monetary-policy jobs. Certainly, a central banker without an economics PhD could struggle to hold his or her own against a large staff fluent in the models and jargon of academic economics.
Given this, many view a doctorate as a prerequisite for any Fed chair. But, in Powell’s case, I would argue that it should not be. Having known him since 1990, I can say that Powell has never been shy about asking questions. As a result, he has developed the analytical capabilities that a Fed governor needs. Almost as important, he won’t have a chip on his shoulder when dealing with more credentialed staff. From my perspective, Powell would stand out as one of the best appointments Trump has made.
The third potential candidate, Kevin Warsh, is a former Fed governor, who also has a background in finance – in this case, at Morgan Stanley – rather than in academic economics. But that is where the similarity between him and Powell ends.
Warsh, like many Republicans, has harshly criticized the Fed’s attempts to stimulate the US economy in the aftermath of the global financial crisis, warning that the unprecedented expansion of the monetary base brought about by quantitative easing would trigger high inflation. Warsh started making such hawkish – and clearly incorrect – warnings in 2010, when unemployment was 9.5% and runaway inflation was the last thing most economists were worried about. One can’t help but wonder if Warsh understands how the economy works.
The same cannot credibly be asked about the fourth candidate, John Taylor. Like Yellen, Taylor is an eminent economist with an impressive record both in academic research and as a practitioner of macroeconomic policy. In fact, he is the sixth most widely cited monetary economist, owing his renown especially to the Taylor rule, a guideline for setting interest rates in response to observed inflation and growth.
Nonetheless, like Warsh, Taylor has long believed that monetary conditions are excessively generous. That criticism was probably warranted during the housing boom that resulted in the 2007-09 financial crisis. And Taylor was in an ideal position to deliver that message, because he served as Under Secretary of the Treasury for International Affairs until 2005, which means that he met regularly with Greenspan, then the Fed’s chair, in private. One wonders why, if he is so opposed to easy monetary policy, he didn’t convey that to Fed governors at a time when the message might have done some good.
The White House’s final potential pick, Gary Cohn, is currently the director of Trump’s National Economic Council. But Cohn, who has no background whatsoever in monetary economics and whose views are unknown, may already be out of the running.
The complaint of most Republican leaders since Obama took office in 2009 is that monetary policy has been too loose. (Trump said the same when he was campaigning for the presidency, though, once in office, he suddenly proclaimed himself a “low rates guy.”) House Republicans wanted the Fed to adopt Taylor-style rules then; now, they want Trump to appoint Taylor himself.
But, historically, Republicans have pushed easy monetary policy when they have had the presidency. If, as is likely, financial markets and the economy run into headwinds in the medium term – perhaps in the run-up to the next presidential election – Trump will almost certainly blame his troubles on the Fed. The complaint, however, will not be that monetary policy is too easy, but that it is too tight.
Good central bankers wouldn’t heed such politicized criticism either way. They would make decisions based on what they believe is best for the economy, relying on evolving data, not on evolving political imperatives. The sitting governors have demonstrated the ability to do that.