Federal Reserve officials like to say the Fed is above politics. It’s even designed to be that way.
The Board of Governors of the Federal Reserve System supervises the Fed. Individual governors vote on changes in interest rates and other policy decisions.
Governors serve 14-year terms. One term expires every two years. That prevents any one president from filling the board with his or her nominees.
An appointed chair heads the Board of Governors. Fed chairs serve four-year terms. The chair’s term ends in the middle of the president’s term. This is another step toward freedom from political interference.
Despite these safeguards, the president still has a significant impact on the Fed since each president appoints a chair. President Donald Trump now has his chance to leave his mark on the Fed.
Remaking the Fed
Trump will soon decide on the next chair from what advisers say is a list of three finalists. The current chair, Janet Yellen, is still in the running. Insiders say the two front-runners are current Fed Gov. Jerome Powell and Stanford economist John Taylor.
Powell’s philosophy is like Yellen’s. He would bring little change.
Taylor, on the other hand, could remake the Fed into a rules-driven machine. He defined a rule to determine the right interest rate. This rule would replace the use of judgment like the Fed currently does.
Taylor’s rule looks at inflation and gross domestic product (GDP) growth, a common measure of economic activity. The result is an objective measure of what the interest rate should be. The current system sets interest rates based on the best guess of Fed governors.
Usually, the best guess is close to the rule’s answer. But, right now, the gap between the two is significant. The effective fed funds rate, the Fed’s benchmark for short-term rates, is the red line in the chart below. Taylor’s rule is the blue line.
(Source: Federal Reserve)
The Fed is holding rates about 3% below the level suggested by the Taylor rule.
This is important because when rates are too low, inflation can take hold. The Fed may be slow to respond to inflation while Taylor’s rule acts quickly since it’s data driven.
The Wisdom of Having a Rule
Economists debate the wisdom of having a rule, but a rule would help the Fed avoid problems. A rule would also help the Fed respond in the face of a crisis like it faced in 2008. The Taylor rule suggests that rate cuts should have started about three months earlier, and that could have prevented large losses in the stock market.
The rule also identifies when negative rates are appropriate. It shows when economic growth supports higher rates.
And a rules-based Fed would lead to higher highs in the stock market since traders would know what the Fed is going to do.
Current Fed officials admit transparency is good. Several policies tell traders what to expect. This includes the chair’s quarterly press conferences.
As chair, Taylor would reduce the importance of the Fed’s meetings and press conferences. He would impose discipline on the process.
Taylor would change the Fed forever, and Trump’s legacy on monetary policy would stand alongside President Ronald Reagan’s, who appointed Alan Greenspan.
Michael Carr, CMT
Editor, Peak Velocity Trader