Who will be the next Fed chair?

On the campaign trail, now President Donald Trump made it pretty clear that he wanted Janet Yellen gone as the Chairperson of the Federal Reserve.  Now in a televised speech on Instagram last week (see here), President Trump offered the biggest clue to his intentions by dropping in the word "hopefully" in his wish that "they will do a fantastic job".  That "hopefully" is, in my view, a definite hint that change is on the way, as if he really had another Yellen term in mind he wouldn't have needed that "hopefully" word. As in so many areas with President Trump, he will break precedence if he doesn't reappoint Chairwoman Yellen, as every Fed chair in modern history who has completed a first term has been nominated for a second term.

So now that I believe it is fairly clear that he has signaled that he will replace her, the media has been looking at the candidates that the President has in mind, and focusing on the daily rumors that appear to emanate from the White House about who is in favor.  But the decision is not as easy as you might think, and for two reasons: i) the President has economic growth objectives that many conservative central bankers might see as unlikely and therefore may try and be more hawkish on monetary policy than otherwise would be the case; and ii) the end of the business cycle expansion is approaching, so the President would likely not want a Fed Chair that is inexperienced in the art of central banking.

This is probably the most important appointment that the President will make in his current term of office, as the likelihood of an economic downturn is extremely high, given that we are coming towards the end of the expansionary phase of the business cycle.  Whoever the next Fed chair is will very likely have to cope with a recession, and will have to position the Fed accordingly.

Therefore, in my view, given that Yellen has effectively dropped out of the race, there are really only 3 candidates left in the running. I will deal with each one separately below:

i) Jerome Powell.  Powell is currently on the Fed Board of Governors, so is no stranger to the Fed.  He was appointed to the Board in 2012 and is a card-carrying Republican as well as a multimillionaire having worked at the Carlyle Group.  He is moderate when it comes to monetary policy views but is not an economist, which may be seen by some as a weakness.  Nevertheless he clearly understands monetary policy well, but may not be the right guy for the job if the economy has another severe recession in the next 4 years.

ii) Kevin Warsh.  Warsh was first appointed an economic advisor at the White House in 2002, and then from 2006 to 2011 Warsh served as a Fed governor, but then resigned to join the Hoover Institution where he is currently employed.  He has been a frequent critic of the Fed, and there are already a website that has been established to lobby against his appointment (see here).  He is definitely seen as more of a hawk, and the consensus is that monetary policy would likely be on a tighter trajectory. He was trained as an economist, so that is a plus, but on the other hand many of his predictions when he was previously employed at the Fed (such as higher inflation if the Fed maintained QE) have not transpired, which doesn't give the markets much confidence in his judgment.

iii) Professor John Taylor, is the only distinguished economics professor among the  candidates. He is the author of the so-called "Taylor rule" which was an effort to use a rule-based setting of monetary policy for modelling purposes.  Taylor was at the US Treasury during the George W. Bush administration and served at the White House under Presidents Carter and Ford.  Through his comments on the maintenance of QE, the markets view him as somewhat hawkish, and the media believes that a Taylor appointment would "spook" the markets.

So what is the perception of the odds for each of these candidates?  The website "Predictit" (see here), has odds based on actual bets, and as of Nov 1st at 11.30am, the odds currently are:

So what is my assessment?  For me this comes in 3 parts - i) who will Trump choose and ii) who would be the best choice in my assessment; and iii) who would actually be best for stockmarket gains?  Let's deal with each in turn.

First, who do I think Trump will choose?  It seems that the President has changed his mind almost daily, so although the latest anonymous leak from the White House stating that Powell is the favorite (see here), I doubt this will be sustained until the announcement.  My belief is that Trump will want to go with an economist and someone who will shake things up at the Fed, as he will want to please his base and also impress other Republicans on Capitol Hill.  So my guess is that Trump will go with Taylor as long as he has Taylor's assurances that he will not enact a rules based policy as this would tend to raise rates faster than would be the case with the other candidates and might then derail the so-called "Trump rally" and spook the markets.  Of course if a Taylor appointment is made, then the markets might still be temporarily spooked until they can get reassurance during the Senate confirmation process.

Second, who do I think would be the best choice for the top job at the Fed?  I believe that continuity is important here, and that likely another Yellen term would actually be best for the country as a whole, as Yellen is already acting on "normalizing" Fed policy, but is doing so at a cautious rate that allows for economic growth to be sustained going forward.

Third, who would be the best choice for the markets?  I think the markets, as the polls show, would prefer Powell, as he possesses the element of continuity, but at the same time is a little more "light touch" on financial regulation than Yellen.

What is almost certain though is that whoever takes over at the Fed (unless it is a Yellen reappointment) will change Fed policy going forward, and that will undoubtedly impact the bond markets and perhaps the pace of interest rate hikes and the withdrawal of the QE stimulus, with its attendant effects on economic growth.  

The Unlikely Miracle of an Immaculate Monetary Exit

Recently, The Economist magazine reported (see here) that Richard Barwell of the Royal Bank of Scotland had made the comment that, for central banks to withdraw from the massive monetary stimulus they have delivered to the economy without any problems, then the stimulus should be withdrawn before the economy really is back on track again, and also for "central banks' economic forecasts to be unerringly accurate".  But in my view there is much more to this than just the timing of the withdrawal of the stimulus, particularly in the US, or the accuracy of central bank forecasts.

If one looks at the 10 and 30 year US government bond yields going back to the beginning of 2008, so just before the "great recession" started, from the chart below you can see that 10 year bonds were at 4% and 30 year bonds were at 5%.  What is astonishing about this chart is the big fall in US long bond yields that occurred in the late summer of 2011, and you might immediately assume that this marked the beginning of one of the "QE" programs of quantitative easing mounted by the Fed.  But you'd be entirely wrong here - it was essentially the beginning of "operation twist", where the Fed committed to buying more longer term Treasuries, or moving further down the maturity spectrum by buying more longer term bonds and selling shorter term ones.

We have never returned to those post-recession higher levels for 30 year bond yields ( - the 4-5% range), nor the 10 year bond ( - 3-4% range), despite having inflation that is roughly the same, if not higher than during that period.  Even during the "taper tantrums" of 2013, 30 year rates never quite got to 4%, and 10 year bond yields only briefly touched 3%.  Not only that, but the gap between the yield rates has been shrinking so that since early 2013 it is a full 0.5% smaller.

Let's have a look at real bond yields for the same maturity bonds (courtesy of the US Treasury's bond pages here). What's clear is that the "operation twist" announcement sent US 10 year real bond yields into negative territory for all of 2012 and the first half of 2013.  It's also noticeable that US real long bond yields are now not negative ( - but of course short term bond rates are). But it is also clear that it would be pretty exceptional circumstances that would send the US 10 year real bond yield into negative territory. In other words, to quote the pop band Yazz - "the only way is up"!

That also makes sense when considering both inflation and real GDP.  Current inflation is 2.1% on a year over year basis in June,   and current real economic growth on a year over year basis in Q2 is at 2.43%, not at all bad, considering the set back to output that the economy had in Q1 due to all the bad weather. Heck, some components in the CPI are just skyrocketing - such as Meat, Poultry, Fish and Eggs (up 7.5% yoy).  These are all products that we eat, and no doubt they will feed into higher grocery bills pretty quickly.  These levels of macroeconomic performance hardly warrant long interest rates in nominal terms at 2.5% or in real terms at 0.25%.

 

In other words, I would expect to be seeing both short and long interest rates at much higher levels than they are right now, but particularly longer rates, given that the economy is likely to be going through more rapid growth going forward than it has in the recent past.  All these predictions about continuing sluggishness in the economy have been underpinned by the Fed's continuing commitment to low interest rates ( - Yellen's claim that the FOMC is in "no hurry" to raise rates), and their "gradualist" ( - some might say irresponsible) and non-differentiated taper. 

 

And that is the danger.  The "gradualist" approach might be just a tad too gradual - and stimulative.  As central bankers are fond of saying, the Fed's job is to pull away the punch bowl just as the party gets going. But in my view the trouble is that the Fed is still spiking the drinks, when already some of the party guests appear to be a little tipsy. 

 

One of the biggest dangers that Fed Chairperson Janet Yellen faces is that she doesn't act quickly enough. After previous recessions, the Fed was often too late in tightening policy and the result was having to rapidly adjust interest rates upwards extremely quickly. Unfortunately the slowdown in Q1 might have laid a trap for the new Fed Chairperson, in that it was a brief blip that has perhaps served to obscure what is really happening with the real economy.

 

All I can say is that I hope I am wrong here, and that the Fed is on course, but I think as each week passes the likelihood is that it is falling rapidly behind the curve on this recovery, and probably more worrisome, as the long bond yields show, that the bond markets have bought the Fed's arguments, lock, stock and barrel.

March Madness, then April Fools, and they didn't go away in May!!

So spring is now over in South Texas as temperatures head back into the 90s and 100s after a colder than usual winter.  But of course the transition from winter to summer is punctuated with March Madness and then the foolishness of April, before the academics and market participants traditionally "go away in May".  This March and April have been particularly crazy, what with more cold weather in March and April, and some really eye popping things going on in the real economy as well as the financial markets.  With bond yields heading lower for no apparent sane reason, I was thinking that this must be an extended bout of March madness and April fools, and that things will correct themselves in May, but alas things have now started to get completely out of hand.

US PPI food (mom): Source BLS

US PPI (yoy): Source BLS

Any economist looking at the PPI numbers released last week for April (see http://www.bls.gov/ppi/ for a breakdown) would interpret this as an uptick in inflation.  The chart taken directly from the BLS website below for year over year producer price inflation shows this.  But what is more surprising is that the food component of the index appears to be definitely showing a spike upwards.  The next chart shows this for the food component of PPI on a month over month basis (2.1%), which comes in at a 5.2% year over year rate.  Now I don't know about you, but I tend to have to eat food, and so this will likely feed through (sorry about the pun) into the CPI pretty quickly, and will affect a whole bunch of things, including supermarket prices, eating out, cruise prices, and anything where food is involved.  

Source: US Treasury website

Now given this, I would have thought that bond yields would have "popped" as a signal (albeit not completely confirmed) that the PPI increases would be a pre-cursor to higher inflation and therefore a quicker move to monetary policy tightening.  But no, bond yields didn't increase, or stay constant, they moved sharply lower. The figure below shows how at the longer end bond yields definitely moved in a downwards direction, while short rates still appear to be anchored at almost zero by Fed monetary policy. This is fast becoming unsustainable as we shift gears to a more growth-inflationary environment. Anyone who has booked an airline ticket, bought a vehicle or been to a supermarket lately knows that prices are definitely moving up as the economy firms.

Now there are some economists who seem to think that the negative Q1 US GDP figures (-1% quarter over quarter at an annual rate) point to an economy teetering on recession or at least in a slowdown or holding pattern.  I think they are dead wrong.  Why?  Well first the way in which the US measures it's economic growth is strange to say the least. I know that -1% shrinkage in the US economy sounds bad, but this is simply due to the compounding of what was a bad weather related quarter.  A more sensible way (which most other countries use) to measure economic growth is to use the year over year change in real GDP.  If we do this, we find that real GDP increased by 2.05 percent - which is not exactly a roaring economy, but it is not bad at all.  Second, with strange weather patterns, it becomes really hard to work out the seasonal adjustments that should be done on the data.  If you use a quarter on quarter measure to assess economic growth, then you have to do seasonal adjustment and any errors are then compounded when you multiply up the figure to an annualized rate.  Using a year over year rate obviates all those problems as you don't have to worry about seasonal adjustment as you are comparing figures from the same season of the year.  

So to the left I have plotted the log change in real US GDP ( - this is just the same as doing a % yoy change calculation).  It is clear that even with the really bad weather that the US economy experienced in the 1st quarter, that the economy is humming along, and in year over year terms, the rate is roughly in line with what we've been seeing for the past couple of years.  

But of course, this means that without the bad weather, the year over year rate might have been significantly higher, perhaps a full 0.5% higher, in which case the economy in fact would have been expanding at it's fastest rate since the last recession ended.  

Now if my view is right, the Fed must be starting to get worried that what it is (not) doing is being misinterpreted as a signal to the markets that it will not move if inflation really does start to move higher as it looks to be doing right now.  When I hear Janet Yellen stating that interest rates will remain low for the next 5 to 8 years, I think some in the market interpret this as easy money for the next 5 years at least, but what they don't seem to understand is that the economy is cyclical. 5 years have now passed since the end of the last recession, so that as we move forward over the next 3 years another downturn becomes more and more likely. In other words, given the history of business cycles we are likely already more than half way through the current growth phase of the business cycle. The Fed therefore will likely have to move fast in order to "normalize" monetary policy so it can be prepared for the next economic downturn.  And in that last sentence you notice that I am not saying "if" it comes - no, it will come alright, and in my next econoblog I will show how some of the research that I am doing looks at these cycles in growth highlights the continuing fluctuations in growth patterns and how they can be interpreted as following a cyclical pattern.

Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.