Will Jerome Powell steer the Federal Reserve through choppy waters in 2018?

Whether we see US inflation expectations and ultimately core inflation start to head toward the Federal Reserve target in 2018, is a dynamic fundamental traders are already thinking about.

So while we have seen some softness in inflation expectations through Q417, if we do see signs of genuine price pressures coming through in the quarters ahead, then how aggressively the Federal Reserve (Fed) alter policy will dictate moves in financial markets throughout 2018.

We have to hope that the correct personnel are in place so that the US central bank gets its monetary policy settings just right or the consequences could be severe and far-reaching. Keep in mind that a policy mistake from the Fed is, without doubt, the biggest macro concern held by economists, fund managers and strategists of any at present.

Aside from inflation trends, where the Fed has made it perfectly clear they are most interested in wage growth. However, the other aspect that is concerning the Fed is around the risks to the financial system. The idea that after nine years of low interest rates and a 390% expansion of their balance sheet (through asset purchases), at a time when the US labour market is trending down towards 4% and the US and the global economy is running above trend at 4%, is keeping them awake at night.

So the focus then is on the individuals within the Fed, how they see economic trends developing in 2018 and how willing they would be to alter monetary policy, should the need be there.  

Jerome Powell as the Fed Chair

One has to start with Janet Yellen’s replacement and the appointment of Jerome Powell as the new Fed chair, with his tenure starting on 3 February. In some capacity, the market knows less about his views on monetary policy than many actually realise, with the majority of Powell’s communications in recent times focused more on regulatory issues. His views on monetary policy have generally toed a central line and he has never been an outlier. From this point of view, and when married with the idea that he has been an advocate for a December rate hike and three more in 2018, which is akin to Janet Yellen’s, so traders have seen his posting as a smooth and market-friendly transition.

Who is Jerome Powell?

 

The cynics would argue that he was only appointed as a Fed Governor in 2011, because Barack Obama required a Republican in the mix to balance things out. These same people would also point out that Powell doesn’t fit the mold of a traditional Fed chair having been a lawyer and working within private equity, as opposed to holding a PhD in economics and coming from a deep background in academia. One has to only look at how aggressively Ben Bernanke responded to the Global Financial Crisis (GFC), where he radically eased monetary policy and ultimately setting the platform for Janet Yellen to steer the US economy to robust growth and full employment.

The irony now is that many of these highly unconventional measures imposed by Bernanke may actually lead to the next crisis in the US, of which Powell will need to lead the US central bank through. So, while he does have six years’ experience within the Fed, one questions if he perhaps lacks the deep knowledge and foresight for the huge challenges the Fed may face in any future crisis.

From what we do know Powell is a pragmatist and will continue to be data dependent. His views on financial stability are perhaps not as well-known as others, but that may change as he is tasked with reducing the $4.45 trillion balance sheet at a time when Trump’s tax cuts will provide a fiscal stimulus to the US economy in 2018. Powell will almost certainly be expected to delve deeper into his views on policy if he wants to be as transparent as say, Ben Bernanke or Janet Yellen. And thus gain, the trust of market participants, who love the idea that we are seldom surprised at FOMC meetings, where most of the information is known prior to the actual meeting. This idea of predictable Fed policy and forward guidance is one of the strong contributing factors as to why volatility has been so subdued through 2017.

Rotation of Fed voters in 2018

Another thing we absolutely need to consider is that the Fed Chair has just one vote at FOMC meetings, within the collective of 19 members. Clearly, Powell’s voice carries significant weight, but these days the FOMC is a democracy, so we need to think about the fairly radical change that is occurring within the central bank and how that could influence policy and subsequently financial markets.

As things stand, there are still four positions as Fed Governor vacant and up for grabs, and this includes the Vice-Chair role which is obviously extremely important. It seems three names have been shortlisted here, including Kevin Warsh, John Taylor and Mohamed El-erian. The market has different interpretations of how they would react and vote for changes to monetary policy, as well as how they would interact with Powell.

New York Fed Governor, Bill Dudley, announced his retirement recently and steps down in mid-2018 and recall this role is part of the core of the Fed (along with the chair and the vice-chair), so this position will need to be filled soon.

We also have the annual rotation, in which we see those tasked to actually vote on policy change hands. What is important here is that after the rotations in January, which sees a number of the more dovish members being replaced by more hawkish members, is that only one voting member (in 2018), Lael Brainard, comes close to holding a view on future rate hikes in 2018 that is in-line with the current market pricing of one hike in end-2018.

All other voting members have given a view that they feel at least three hikes will be needed.

So who runs and votes within the Fed in 2018 is one of the most important market dynamics to think about and how this group of individual manage lower or higher inflationary pressure will dictate financial markets throughout the year ahead. The question then we need to think about is while we obviously don’t know what exactly will play out next year, do this group of individuals have the ability and foresight to set monetary policy correctly?

It promises to be a fascinating year ahead for investors and traders alike.

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