Reasons to be optimistic about the Fed

Richard Clarida
— 1 minute read

The appointment of Jerome Powell as the next chair of the US Federal Reserve, assuming it is approved by the US Senate, is a smart choice, writes Pimco’s Richard Clarida.

President Donald Trump announced US Federal Reserve governor Jerome Powell as his nominee for chair of the Federal Reserve board on 2 November.

A Fed governor since 2012, Mr Powell has been confirmed twice by the US Senate and likely will be confirmed as chair without controversy in time to take over when current chair Janet Yellen’s term expires in February 2018.

'Jay' Powell, a lawyer by training, served in the 1990s as a senior official in the US Treasury and, before joining the Fed, was an executive with the Carlyle Group.

Mr Powell, who has never dissented in a monetary policy vote during his service as governor, is expected to maintain the framework for policy normalisation put in place by the Yellen Fed.

For 2018, the Fed guidance currently in place calls for rates to continue to rise gradually, with the median Fed projection that three hikes will be appropriate next year if the economy performs as forecast.

We expect likewise for the Fed’s current plans for shrinking its balance sheet, a process which commenced in October. This plan – which Mr Powell helped develop – has been well-communicated to markets and has so far not triggered a replay of the 2013 taper tantrum.

It calls for a predictable reduction each month in the Fed’s holdings of Treasuries and mortgage securities.

On financial regulation, Powell has acknowledged that a case can be made for modifying the Volcker rule and for making it easier for smaller banks to comply with the Fed’s annual stress test exercise.

In 2019 and beyond, a Powell Fed must make crucial decisions – left unresolved by the Yellen Fed – on when and how to end the process of policy normalisation.

Specifically, at some point the Fed will have to decide when to stop hiking interest rates and when to stop shrinking the balance sheet.

In his public statements, Mr Powell appears to embrace Pimco’s New Neutral concept that the destination for the federal funds rate during this rate hike cycle will be a much lower level than was the case before the global financial crisis.

However, Fed officials don’t agree on what this New Neutral level is, and Mr Powell will need to forge a consensus somehow.

It’s a similar story for the Fed’s balance sheet normalisation. Today, all Fed officials agree that the balance sheet should be smaller, but there’s no agreement on the optimal ultimate size. At some point, as Fed chair, Mr Powell will have to build consensus for this policy decision as well.

Also on the horizon, at some point in the next four years the US could fall into a recession. The current expansion is already the third longest in US history, and while there are few signs that a downturn is imminent, the historical odds of avoiding a recession in next four years below 50 per cent.

In a downturn, the Powell Fed would most likely have less room to cut rates in a new neutral world than did the Fed did in past recessions. If so, the Powell Fed would have to consider and reach consensus on additional options for policy easing including forward guidance and possible QE.

We believe Jerome Powell is a smart choice for Fed chair. He is likely to provide continuity in the monetary policy framework developed by the Yellen Fed for a gradual normalisation of the policy rate and a predictable reduction in the Fed’s balance sheet, though in the longer term the Powell Fed will have some critical decisions to make about the ultimate destination for both the rate and the balance sheet.

Also, we note that Powell is probably more receptive to concerns that the pendulum in financial regulation has swung too far, and therefore more open to suggestions for prudent adjustments, especially for smaller banks.

Richard Clarida is managing director and global strategic advisor at Pimco.


Reasons to be optimistic about the Fed
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