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Investment Research — General Market Conditions

13 February 2017

Research US Trump to nominate three Fed governors as Tarullo resigns 

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President Donald Trump now has to nominate three Fed governors, as Daniel Tarullo has announced he will step down on 5 April. While Trump has expressed different views on monetary policy, we think it is most likely that he will appoint hawkish governors.

US research  FOMC review: No major changes

to the FOMC statement

Fed Chair Yellen’s and Vice Chair Fischer’s terms expire in 2018 (in February and June, respectively) and Trump has indicated he would be likely to replace them. One of Trump’s nominees for the three vacant seats is likely the next Fed Chair.

 FOMC preview: Fed is still waiting

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Trump is likely to nominate a total of five new governors over the next two years, as Yellen and Fischer are expected to leave the Fed if they are not reappointed.

and UST yields will head higher

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The Fed may become more rule-based in coming years due to Trump’s nominations. A simple Taylor rule based on PCE core inflation and output gap suggests the Fed funds rate should be 3.0% currently. It is more difficult to predict the impact on overall US yields, as it also depends on the impact on inflation expectations.

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The Fed’s independence may come under greater pressure, as tighter monetary policy would offset Trump’s expansionary fiscal policy, which could frustrate him.

Trump to nominate three Fed governors Daniel Tarullo announced on Friday that he intends to resign ‘on or around 5 April’. This is not a big surprise since Tarullo has been the de facto vice chair for bank supervision (although he never officially got the position) and has been in charge of implementing Dodd-Frank. President Trump has made it clear on several occasions made that he wants to reduce and remove financial regulations. With Tarullo resigning, President Trump now has to nominate three new Fed governors, as two out of seven seats in the Board of Governors are already vacant. Governors are non-rotating voting FOMC members and thus very important for monetary policy decisions. Trump is nominating the governors but they are subject to Senate confirmation before they can take office (simple majority is needed). Trump’s nominee for Secretary of the Treasury, Steven Mnuchin, said in a CNBC interview that it is ‘high on the priority list’ to fill the vacant seats. The law states one of the two vacant seats on the Board must go to a person with community bank (which has assets for less than USD10bn) experience, which shrinks the list of potential candidates.

for news on Trumponomics  Strategy: noise vs fact: why USD

 FX Edge: US Treasury Q1 cash

deluge to ease USD support nearterm

Trump to nominate three Fed governors in coming months Governor Yellen

Term expires Feb 3, 2018 (as chair) Jan 31, 2024 (as Governor)

Fischer

Jun 12, 2018 (as Vice Chair) Jan 31, 2020 (as Governor)

Tarullo

Resigns on April 5

Powell

Jan 31, 2028

Brainard

Jan 31, 2026

Vacant Vacant Source: Danske Bank Markets

President Trump has only talked about monetary policy a few times where he has expressed different views, which have been contradictory. During the election campaign, he criticised Yellen’s low interest rate policy for creating a bubble economy but recently said that the strong dollar “is killing” the US, as it has made the US less competitive. The nominations will send signals about whether the Fed is turning more hawkish or Trump wants a dovish Fed to support his expansionary fiscal policy. Given President Trump’s possible disinterest in monetary policy, we think he will be advised to appoint hawks but we have to follow his comments on monetary policy closely.

Senior Analyst Mikael Olai Milhøj +45 45 12 76 07 [email protected] Assistant Analyst Andreas Mey Kjøller [email protected]

Important disclosures and certifications are contained from page 5 of this report.

www.danskeresearch.com

Research US

Trump likely to replace Yellen with new Chair Janet Yellen’s term as Fed Chair ends in February 2018 and Trump said during the election campaign that he would likely not reappoint her, which is quite unusual. Barack Obama (Democrat) reappointed Ben Bernanke (Republican) for a second term in 2009, Bill Clinton (Democrat) reappointed Alan Greenspan (Republican) twice and Ronald Reagan (Republican) kept Paul Volcker (Democrat). We think Trump will continue to ‘drain the swamp’ and nominate a new Chair, especially after his harsh comments during the election campaign. We also know he wants his own people in key positions. Trump is also most likely to nominate a new Vice Chair when Fischer’s term expires in June 2018, in our view. As the Fed Chair has to be one of the seven governors, one of Trump’s nominees is likely to become the next Fed Chair. Several names have been mentioned in the press as possible candidates to succeed Yellen: John Taylor, Stanford professor known for the ‘Taylor rule’; Glenn Hubbard, Dean at Columbia business school; and Gregory Mankiw, Harvard Professor and former Chair of the Council of Economic Advisers.

Trump may appoint five Fed governors in coming years Theoretically, both Yellen and Fischer could serve the remainder of their terms as ordinary governors even if they are not reappointed as Fed Chairs by Trump. In reality, we think it is unlikely and think both will leave the Fed afterwards. If that is the case, Trump would need to nominate two more governors, making it a total of five. Trump would then have appointed five out of 12 voting FOMC members (five out of seven governors, Trump has no say with respect to the Regional Fed Presidents) and although they will not have majority, it is enough to shift the power balance to the hawks assuming Trump nominates hawks. Governors are supposed to serve 14-year terms to prevent one president from having too much influence on the Fed in order to ensure the Fed’s independence from party politics. In reality, governors usually leave the Board prematurely and the average term-length of governors quitting after 1980 is only six years including Alan Greenspan, who served 19 years as Governor and Chair. Note that President Obama has appointed all current Fed governors. Also, two of the regional Fed Presidents are leaving this year, as Atlanta Fed President Dennis Lockhart and Richmond Fed President Jeffery Lacker retire on 28 February and 1 October, respectively. The two successors will both be voting FOMC members next year, which increases the importance of the selection. President Trump has no say in who will succeed Lacker and Lockhart, as it is up to the respective Reserve Banks to find the next President in collaboration with the Board of Governors.

Fed may become more rule-based While President Trump does not seem very interested in monetary policy and the Fed, the Republican Party certainly is, as many Republicans are dissatisfied with the Fed’s low rate policy. Back in November 2015, the House passed a bill called “Fed Oversight Reform and Modernization Act” (see Reuters), which would have forced the Fed (against its wishes) to base its monetary policy decisions on a policy rule. Deviations from the rule would lead to a congressional audit. While such a bill would likely be filibustered in the Senate by the Democrats, the Fed may de facto shift to a more ruled-based policy when President Trump has nominated the majority of Fed governors. John Taylor, a potential new Fed chair and founder of the so-called Taylor rule, has previously said that the Fed should ‘return to rule-based policy’, as ‘discretionary interventions are unpredictable’, see Bloomberg video. Based on a simple Taylor rule, which links the Fed funds rate to inflation and unemployment, the Fed funds rate should be around 3% now and thus we may be heading for higher US policy rates in the coming

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Taylor rule suggests the Fed funds rate should be 3%

Source: Federal Reserve, CBO, BLS


Research US

years. However, this is in our view too simplistic a way to look at monetary policy, as relatively new academic work suggests that central banks, for whom the lower bound binds, should promise to keep rates lower than usual even after the lower bound is no longer a constraint. Long story short, central banks have to ‘compensate’ for the years when they were constrained and not allowed to ease as much as they should if possible. This is the theoretical framework for why central banks have used forward guidance intensively in recent years. Looking at the Fed, one can argue that the Fed funds rate is still low now because it was not able (or did not want to) lower the Fed funds rate into negative territory at the beginning of the crisis. If the Fed had followed the Taylor rule slavishly in recent years, it would have taken longer to escape from the crisis, according to this theory. The risk is that the Fed will slow the economy down if it raises rates too much, too quickly. The effect on the overall interest rate level is more difficult to predict, as the nominal interest rate is determined by a combination of the real interest rate and inflation expectations, 𝑖 = 𝑟 + 𝜋 𝑒 . Thus if the Fed tightens monetary policy too much, it could actually lead to lower yields through lower inflation expectations. It is an old discussion in economic academic literature whether discretionary or rule-based economic policy is best, as there is a trade-off between credibility and flexibility. If the Fed implements a rule-based strategy, the Fed would be more transparent and it would be easier for investors, businesses and consumers to predict the future interest rate level given their forecasts for growth and inflation. However, the Fed would be less flexible, as it would be more difficult for the Fed to react to other information. This is also the reason why many current FOMC members are against a more rule-based strategy. From an economic perspective, whether it would be a good idea or not for the Fed to become more rule-based depends on the given rule and how strict the Fed needs to follow it. While a rule-based strategy would lower interest rate volatility, the impact on US yields depends on the effect on inflation expectations.

Fed could come under greater political pressure Although President Trump gets the chance to appoint his own people at the Fed, the risk is that we could be heading for a conflict between Trump and the Fed. A more hawkish and rule-based Fed would likely offset Trump’s more expansionary fiscal policy by tightening monetary policy, which could frustrate Trump, as it would make it more complicated for him to fulfil his pledges on employment and growth. We know that President Trump has been very vocal against lawmakers and judges opposing his policies and there is a risk that the Fed’s independence will come under greater pressure if Trump disagrees with the actual monetary policy. Just like the US political system of ‘check and balances’ is designed to avoid one of three branches (legislative, executive and judicial branches) becoming too powerful alone, monetary policy is delegated to an independent Fed in order to ensure a more optimal policy not only aiming at getting politicians re-elected. If the Fed succumbs to political pressure, it would lead to a less optimal monetary policy, which could hurt the economy.

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The three key entities constituting the Federal Reserve System

Source: Federal Reserve

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Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The author of the research report is Mikael Olai Milhøj, Senior Analyst, and Andreas Mey Kjøller, Assistant Analyst.

Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report.

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Expected updates None.

Date of first publication See the front page of this research report for the date of first publication.

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