High FOMC Turnover Makes for Mixed Messages

important factors to consider: First, the individual views of the new and prospective FOMC members, which could tilt the FOMC in a more hawkish or dovish direction; second, the new rotation’s potential influence on the FOMC’s decision-making core, led by Yellen.

The question of who will succeed the departing FOMC members is only partly settled. Loretta Mester, a long-time staffer (head of research and chief policy advisor to Charles Plosser) at the Philadelphia Fed, takes the helm of the Cleveland Fed in June; and former Bank of Israel Governor Stanley Fischer has been confirmed by the Senate to become Board vice-chairman. Lael Brainard, the under-secretary for international affairs at the U.S. Treasury and a former senior member of the National Economic Council, is a nominee for governor. She has yet to be confirmed, but is expected to be sometime in June.

Two more members of the board need to be nominated and confirmed to fill up the body’s seven positions. The Obama administration is likely to choose relative doves – i.e., policy makers who care about both inflation and growth/unemployment and would likely vote in similar ways to the FOMC’s current dovish members. Among the names floated as probable candidates for the board are several distinguished academics: Christina Romer and Alan Krueger (former heads of the Council of Economic Advisors, or CEA, in the first Obama administration) and Janice Eberly (formerly an official at the U.S. Treasury). One of the two open board slots is likely to go to a community banker; Yellen has expressed support for this idea, which is popular in Congress. Traditionally, community bankers are dovish, and they tend to agree with the views of the rest of the board members.

Starting this year, the profile of regional Fed presidents on the FOMC has become less dovish – three new relative “hawks” are in: Charles Plosser from the Philly Fed, Richard Fisher from the Dallas Fed and the new Cleveland Fed head Loretta Mester, who used to be Plosser’s policy advisor at the Philly Fed; only one hawk is out, namely Esther George from the Kansas City Fed. So, the mean FOMC voter is now more hawkish than in 2013.

Fischer: Master of Activist Monetary Policy and Forward Guidance Doubter

The new vice chairman, Stanley Fischer, was responsible for some of the earliest work on activist monetary policy. While leading the Bank of Israel (BI), he aggressively lowered policy rates in early 2008 as the credit markets went into meltdown and then had to reverse course soon after with higher rates and massive currency intervention as the shekel surged in response to the ensuing rapid economic recovery.

Fischer is uncontroversial when it comes to his views on the U.S. economy, which are mainstream. It is his skeptical views on the effectiveness of forward guidance that set him apart, introducing a note of uncertainty into the FOMC. He contends that forward guidance is not credible when the central bank cannot effectively predict the future, and therefore a commitment to keep policy rates low for longer is not very credible if it diverges from the policy reaction function of the central bank. For that reason, Fischer has argued that providing guidance gives the central bank less flexibility when some state-contingent discretion is necessary. Fischer downplayed these views before the Senate Banking Committee, but they could very well remain valid in his mind. He is of the view that the Fed may have over-communicated its policy intentions to the markets, a potentially counter-productive effort that may have made investors too reliant on Fed signaling.

As Yellen is still a strong proponent of forward guidance and transparent communication, FOMC meetings could prove lively as Yellen and Fischer have differing views about forward guidance. At worst, any public comments Fischer may make on the subject could be seen as signaling friction within the FOMC. Ultimately, however, we believe Yellen’s views will mostly prevail, but Fed communication and forward guidance may become less explicit and direct.

Brainard: Likely to Align Well With Dovish Yellen

Brainard’s views on monetary policy are essentially unknown beyond her circumspect opening statement on the subject during her appearance before the Senate Banking Committee. However, her work on poverty and income disparity at the Brookings Institution suggests that she tilts toward dovishness and is generally sympathetic to interventionist policies. Her stint as under-secretary for international affairs at the U.S. Treasury indicates that she will bring a wealth of experience on global economic and market issues.

Mester: Possibly Hawkish Like Plosser

The monetary policy views of the new Cleveland Fed president, Loretta Mester, are also little known, but we believe they are skewed toward the hawkish end of the spectrum. Since Mester retained her role under Plosser, the hawkish Philly Fed president, it seems likely that her views align with his.

Her speeches on the economic outlook have not strayed far from the central tendency of Fed forecasts, but a speech she gave last year reveals some reservations about forward guidance and macroprudential policy tools. Mester pointed out that forward guidance may not work in practice since in the real world there is no perfect commitment (a view shared by Fischer), although she acknowledged that QE played a role in helping to bolster the Fed’s future commitments. She is even less convinced that monetary policy has a role to play in financial stability, as it is difficult to see a bubble forming in advance. She argues that macroprudential tools are in their infancy and it is difficult to calibrate the magnitude of policy needed to assure financial stability. Finally, Mester discussed the Fed’s independence, pointing out that in the fu ture, the central bank may face political pressure to remain in accommodative mode; she also touched on the political implications of a sensitive potential scenario in which the Fed is paying interest on excess reserves to banks while making zero or net negative remittances to the Treasury from its balance sheet.

Nonetheless, having attended most FOMC meetings in her prior role as head of research at the Philly Fed, Mester is well acquainted with the committee’s inner workings.

The Fed Now Less of an Absolute Monarchy Than Under Greenspan

Under Alan Greenspan, the FOMC was close to an absolute monarchy as the views of the chairman were dominant and accepted by the rest of the committee. Under Ben Bernanke, the FOMC became a cross between a constitutional monarchy and a collegial democracy, as the chairman had to work hard to ensure that his views were shared by the majority of the FOMC. That required a constant dialogue between the chairman and the rest of the Board to ensure that a majority of the FOMC would agree with the chairman’s views. Bernanke was frustrated by the cacophony of views expressed by FOMC members – voting and otherwise – and he instituted press conferences in part to ensure that investors were clearly aware of the FOMC’s central view, despite the noise coming from speeches and public comments made by individual FOMC members. Close interactions between board members at least ensured some coherence of views within this group, but, even with the press conferenc es, the Fed cacophony never stopped as regional Fed presidents continued to express publicly views that differed from the FOMC median.

Under Yellen, the Fed will remain as much of a constitutional monarchy (or possibly even a collegial democracy) as it became under Bernanke. Yellen has a collegial personality and approach and will work hard to ensure that she takes views close to those of the rest of the FOMC. For example, she has previously expressed sympathy for the idea of optimal control – i.e., allowing inflation to increase above the Fed’s 2% target to allow the unemployment rate to fall below the non-accelerating inflation rate of unemployment (NAIRU) for a while, thus allowing a faster reduction of labor-market slack generated by years of low employment. But the idea of optimal control never garnered a majority within the FOMC, as there is a risk that once inflation rises above target, inflation expectations would become unhinged. Thus, as Fed chair, Yellen has already stopped supporting optimal control, a shift in stance from her days as vice-chair. She also aligned herself with the rest of the FOMC in December – before becoming chair – by supporting the start of QE tapering.

The FOMC Still Has a Dovish Majority

The Fed chair still wields significant power and is likely to have a board that remains relatively dovish: indeed, under Bernanke, the board became more dovish over time and moved closer to Yellen’s views. In spite of all the changes, the voting FOMC still has a majority of relative doves (Daniel Tarullo, Jerome Powell, William Dudley and Narayana Kocherlakota, as well as Fischer and Brainard when confirmed) who will align with Yellen’s views on the economy. Once the two additional board vacancies are filled by Congress, this dovish majority will be reinforced.

In her April 16 speech to the Economic Club of New York, Yellen offered a detailed explanation of the central bank’s current thinking on forward guidance and policy rules, and set the groundwork for a coherent forward guidance message. Coming after her remark about a six-month lag between the end of QE and the start of rate hikes, Yellen’s speech was a form of corrective action, highlighting the high degree of labor-market slack and the weak inflation outlook; the market correctly interpreted these signals as dovish with respect to policy rates.

Fed Must Next Devise a New Policy Rule

With markets and investors now focusing on the date of the first rate increase – as the tapering schedule is on track to be completed by October – the key issue for the Fed will be to communicate to markets which rule will be followed regarding the pace and end point of policy normalization once rate normalization begins. With regard to the end point, the neutral long-term fed funds rate will be closer to 4% than the higher levels (5.25% and 6.5%) seen during the last two cycles. A 4% neutral fed funds rate is consistent with a 2% inflation target and a 2% real fed funds rate. Historically, the equilibrium real fed funds rate was higher (closer to 2.5-3%), but Fed officials have made several arguments for why the equilibrium real short rate is now closer to 2% – if not lower.

As recently argued by New York Fed President William Dudley, there are three reasons for a lower equilibrium real fed funds rate. First, economic headwinds seem likely to persist for several more years. Second, slower growth of the labor force and moderate productivity growth imply a lower potential real GDP growth rate, which implies lower real equilibrium interest rates even once all current headwinds have fully dissipated. Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Higher capital requirements for banks imply somewhat wider intermediation margins, which is likely to push down the long-term equilibrium federal funds rate somewhat.

Some very dovish FOMC members may believe that the equilibrium fed funds rate may be even lower than 4% (a view that is currently priced in by financial markets), while some more hawkish members believe that an equilibrium rate closer to the historical average of 4.5% is more warranted. This dispersion of views is clear from the forecasts contained in the FOMC’s Summary of Economic Projections (SEP). But for the median FOMC voter, the new neutral rate is 4%, so it seems likely that this will be the neutral rate.

How fast will the Fed get to 4% and with which policy rule? The median FOMC voter sees the fed funds rate at 1% by the end of 2015 and 2.25% by the end of 2016, only reaching the neutral level of 4% toward the end of 2018. This is an extremely slow pace of policy normalization, a process that would last about 3.5 years from start to finish, assuming normalization does not begin until mid-2015. In the 2004-06 normalization cycle, the rate went from 1% to 5.25% in just two years.

The need to use aggressive forward guidance – low for longer relative to even a modified Taylor rule – to make these SEP projections credible to markets is obvious: Since the median FOMC voter forecasts that the unemployment rate will be close to NAIRU by the end of 2016 and that inflation will be close to its 2% target at that time, a fed funds rate of 2.25% by the end of 2016 implies that the real fed funds rate will still be close to or barely above 0%, despite the economy being close to full employment and inflation being close to target. In normal times, such a scenario would have justified a real fed funds rate closer to 1% and therefore a nominal fed funds rate that is closer to 3% than 2.25%. And indeed, some analysts and market participants believe that the Fed will normalize faster than the SEP dots (individual participant’s forecasts) predict, with the fed funds rate close to 3% by the end of 2016.

This is why Fed communication and forward guidance are key. If those within the FOMC who are skeptical of forward guidance (such as Fischer and the hawks) were to have the upper hand, it is likely that markets would start pricing in a more rapid policy rate normalization – closer to 3% by the end of 2016 and closer to the neutral rate of 4% by the



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