Jerome Powell Andrew Harrer/Bloomberg

“In God we trust” is printed on the back of the dollar bill, and it is indeed a faith-based currency. The front of the bill says it is a “Federal Reserve Note,” an indication the faith is placed in that institution, not in any promise to redeem it for something tangible. While the strength of the dollar ultimately depends on that of the U.S.—political and military as well as economic—the central bank that issues the currency has become identified with the person at its helm.
Who will lead the Fed is a vitally important decision for any president, especially for Donald Trump, who has sought to fundamentally change Washington and the U.S. economy. And with Janet Yellen’s term set to end in February, the speculation of whether she gets a second four-year stint or is succeeded by somebody else has been looming large over Washington, Wall Street, and the global markets for weeks.

The candidates for central bank chief appear to be winnowed down to three: Fed Gov. Jerome Powell, Stanford University economist John Taylor, or Yellen herself, with reports on Friday that Trump has settled on Powell as his pick. The president played up the announcement in an Instagram post on Friday, promising to unveil details this coming week. Erstwhile candidates Gary Cohn, the National Economic Council head, and former Fed Gov. Kevin Warsh apparently fell out of the running earlier. (We also offer our own choice, a superstar central banker not on anybody’s short list, in “Our Pick to Head the Fed.”)

Notwithstanding all the buzz and speculation over who will win the competition for Fed chair, investors should realize that the course of monetary policy will not be altered much in the medium term.
John Taylor Tom Williams/CQ Roll Call/Getty Images;
Over the next year, the central bank will continue to raise its key short-term interest rates gradually, and those rates will remain at historically low levels. The Fed also will gradually reduce the size of its balance sheet, reversing some of the extraordinary liquidity it provided in the wake of the financial crisis of 2008-09.

The real change in Fed policy won’t be seen until the next bout of financial market turbulence or the next economic downturn, or both. Will the central bank under new leadership react to a decline in asset prices by slashing interest rates and pumping money into the financial system as aggressively as in the past? And perhaps more to the point, will a Fed led by Trump appointees follow a less restrictive regulatory tack and let markets function more freely? Will that mean profitability for banks and other institutions—but also greater risk when the financial markets encounter turbulence, as they inevitably do? As for the candidates, Yellen, a registered Democrat, was always a long shot to gain a second term, mainly because of politics, despite overseeing an economy with low unemployment and inflation—the Fed’s two main mandates—and a record stock market. Even so, there is ample precedent for her to be renominated by a GOP president. Indeed, each of the past three Fed chairs got nods for new terms after having been originally named by previous presidents of different parties.

Paul Volcker was named to a second term by Republican Ronald Reagan after having been nominated originally by Democrat Jimmy Carter. Alan Greenspan, originally named by Reagan to succeed Volcker, got a third term from Democrat Bill Clinton (after a second one from George H.W. Bush, Reagan’s successor). Finally, Ben Bernanke, who succeeded Greenspan after being named by Republican George W. Bush, secured a second term from Democrat Barack Obama.
Janet Yellen Andrew Harrer/Bloomberg
Precedent counts little for Trump, with personal relationships with appointees having far greater importance. On that score, the president remarked after meeting with Yellen that he liked her “a lot,” a reversal of his sharp criticism of Fed policy during the presidential campaign. Then, Trump charged Yellen was keeping rates low for political reasons—that is, to help the Democrats.

Trump also then criticized Yellen for creating “a false stock market” that would plunge as soon as interest rates rose. Now, of course, the president tweets as the stock market makes new highs—even after the Fed has raised short-term interest rates three times in the past year and is likely to hike them again another quarter percentage point this December.

But a record Dow Jones Industrial Average likely won’t be enough to gain Yellen another four-year term. (Her tenure as a Fed governor runs through 2024, but she would almost certainly step down if she doesn’t get reappointed as chair.) The Fed’s policies have lifted asset prices, not just stocks, but also corporate bonds, private equity, art, classic cars, and expensive houses. Presidents, however, typically prefer to nominate officials of their own party who are more in accord with their policy goals.

THAT MAKES POWELL the leading candidate to succeed Yellen, and the one who has the support of Treasury Secretary Steven Mnuchin, according to various reports. The stock market, for its part, climbed on Friday on reports that Trump was leaning toward picking him. A Republican who currently sits on the Fed Board of Governors, Powell has generally supported the Fed’s policies. But he also is likely to be more inclined to a lighter touch on regulation. Yellen, by contrast, emphasized the need to keep the postcrisis regulations in place in a speech last August at the Fed’s big Jackson Hole, Wyo., policy conference.

Taylor, meanwhile, is a favorite of GOP conservatives who want to curtail the Fed’s power and discretion.

The author of the eponymous Taylor Rule would have the central bank set interest rates according to a formula, which he argues would produce better results because of its consistency and transparency. More to the point, the Taylor Rule would signal substantially higher short-term interest rates—nearly two percentage points above the Fed’s current target range of 1% to 1.25% for federal funds.
The current betting is that Powell could get named chairman while Taylor could get the vice chairmanship, which also is open.

It’s not just about the leadership of the central bank. The president is in the unusual position of being able to virtually remake the entire seven-person Fed Board of Governors. Randal Quarles was just recently sworn in as vice chair in charge of supervision, a post that had been vacant. There are three other vacancies on the board to be filled as well. Lael Brainard could wind up the only holdover on the seven-person Fed Board.

Out of the running now is the previous favorite, Cohn, the former Goldman Sachs executive and head of the National Economic Council, who fell out of the president’s graces for criticizing his comments after the Charlottesville, Va., incident. Warsh, a former Fed governor, also fell out of contention, in part because of critics questioning his qualifications and Mnuchin’s opposition, according to published reports.

BEYOND PERSONALITIES, however, the assessment of Yellen’s Fed should come down to results. And those results are mixed.

As the chart above shows, her most prominent accomplishment has been the record stock market, which has been undeniably buoyed by the low level of short-term interest—near zero from December 2008 to December 2015—and historically low long-term bond yields.

But as the chart also shows, the real (that is, adjusted for inflation) median household income has only recently regained what it had lost in the Great Recession. The recovery has been helped by the decline in unemployment (by the narrow definition that gets the most attention) to 4.2%, which most economists define as full employment. But that has not been accompanied by a rise in inflation to the Fed’s inflation target of 2%. In turn, the growth of median incomes has lagged.

To be sure, the relatively lackluster economic recovery can’t be laid entirely at the Fed’s feet. Monetary policy can’t cure a litany of social issues like demographics, skill mismatches, inadequate education, or the scourge of drug addiction. Whether the buildup of debt at the household, corporate, and government levels has helped or hurt the recovery is a major point of debate.

The Fed’s critics charge that the central bank has held back growth by its interest-rate and regulatory policies. Chief among them is Taylor, who argues against both having held the federal-funds rate so low for so long and against the Fed’s asset purchases, or QE, for quantitative easing.

The Taylor Rule sets the fed-funds rates according to the economy’s potential growth, inflation, and how much slack exists in the economy. Under the formula, the Fed would have started the process of lifting the fed-funds rates much sooner, in 2010. (Importantly, the formula also would have dictated a negative rate target during 2009.) According to a Taylor Rule calculator from the Atlanta Fed, the fed-funds target would be 2.94% instead of the 1.15% it now is.

In past cycles, however, the Taylor Rule actually would have meant smaller changes in the fed-funds rate, according to the Atlanta Fed. During the past decade, when the Greenspan Fed raised the rate in small, predictable quarter-point steps and arguably allowed the mortgage bubble to inflate, the Taylor Rule would have started the rate increases sooner but also ended them earlier. During the 1990s, the Taylor Rule would have avoided the sharp rate jumps in 1994, which roiled the mortgage market and ended with a Mexican peso crisis, and wouldn’t have raised rates as much during the dot-com bubble.

EVEN IF TAYLOR wins the Fed chair, it seems unlikely he would apply his rule in a doctrinaire fashion. At a recent policy symposium at the Boston Fed, he commented: “I don’t think rules should be viewed as ways to tie central bankers’ hands. They are meant to help policy makers make better decisions.”

Still, a Taylor Fed would likely mean “a more aggressive” normalization of policy in terms of interest-rate increases and reduction in the central bank’s balance sheet than is envisioned by the Federal Open Market Committee, write Peter Hooper and Matthew Luzzetti, respectively chief economist and senior economist at Deutsche Bank. (The voting members of the policy-setting FOMC consist of the seven Fed governors and five of the 12 Fed district bank presidents, four of which rotate annually as voting members, with the New York Fed having a permanent vote.) A Taylor Fed also would likely mean a quicker move away from accommodation than the market expects.

That mightn’t be such a bad thing, comments John Brady, managing director at R.J. O’Brien & Associates in Chicago. After all, he says the Eurodollar futures market is discounting only two quarter-point rate hikes through December 2018, which would put the fed-funds rate in a range of 1.5% to 1.75%. The FOMC’s dot plot has a median year-end 2018 estimate of 2.1%.

Higher long-term bond yields would help boost returns for pension funds, Brady continues. In a yield-parched market, investors have resorted to options-selling strategies to earn premiums to augment low yields. That tends to depress volatility artificially, which in turn drags down yields. A somewhat higher bond yield—say, 2.75% on the benchmark 10-year Treasury note, versus 2.42% currently—would help normalize the bond market without imperiling stocks, he contends. So, Brady concludes, there’s little to fear from a Taylor Fed.

FOR THE GOP, Powell as Fed chairman and Taylor as vice chairman sizes up as a central bank dream team. Powell has experience at the Fed and as assistant secretary and undersecretary of the Treasury in the elder Bush’s administration as well as in private equity at the Carlyle Group. Taylor, while never having worked at the Fed, served as Treasury undersecretary for international affairs for the younger Bush. There’s plenty of government experience between them.

What could be a bigger change is how the Fed reacts to future swoons in the financial markets. To many observers, the central bank has paid increasing attention to the equity, corporate bond, and commodity markets. It amounts to “a third mandate,” as Eric Stein, co-director of global income at Eaton Vance, termed the central bank’s attention to financial market conditions, along with its official targets of full employment and stable prices.

At times, Fed heads have expressed caution about the level of stock prices, most famously when Greenspan warned about “irrational exuberance” in 1996, years before the 2000 peak of the dot-com mania. Yellen also warned prematurely in 2014 about valuations among biotechnology stocks being “substantially stretched.”

But more often, the Fed has been quick to ease policy when markets falter, beginning 30 years ago this month when the Greenspan Fed cut rates following the 508-point drop in the Dow on Black Monday. The Fed also cut rates in response to the market turmoil after the collapse of the Long-Term Capital Management hedge fund in 1998 and in early 2001 in the wake of the bursting of the internet bubble. This became known as the “Greenspan put,” a perceived option that protects investors in the event of market decline.

It was succeeded in turn by the “Bernanke put” and now the “Yellen put,” although the current chair hasn’t been put to such a test by a market plunge. But the current Fed chair has given the appearance of being sensitive to market conditions, notably early last year, by putting off expected interest-rate hikes when the stock, high-yield bond, and oil markets came under pressure.

A Fed led by Trump appointees may be less inclined to ride to the rescue of the financial markets, if and when the inevitable selloff hits, some market veterans suggest. In options terms, the Fed put is further out of the money, says Eaton Vance’s Stein, meaning it will take a far bigger hit to prices before the central bank reacts.

Under new leadership, the Fed also may see less unanimity and more independence. Building a consensus was seen as important under Bernanke and Yellen. But, says James Bianco, head of Chicago-based Bianco Research, more-independent-minded Trump appointees might be more inclined to dissent from policy decisions, as is typical at other central banks, such as the Bank of England and the Bank of Japan.

DESPITE TRUMP’S kind words for Yellen and his satisfaction about the stock market’s records reached on her watch, the president more than likely will prefer one of his own men at the Fed. Amid reports the president had settled on Powell, his odds of getting the Fed job jumped to 77% on betting site Friday, with Taylor’s odds dropping to 20% and Yellen at 8%.

Even assuming six of the seven Fed Board members are named by Trump, monetary policy in the short and medium term is unlikely to deviate much from its anticipated course. The futures market is betting on an even smaller rise in rates than the modest increases the FOMC anticipates. The shrinkage in the Fed’s balance sheet is supposed to proceed so uneventfully that Yellen says it should be like watching paint dry.

(Don’t forget the European Central Bank and the Bank of Japan will still be buying and adding to global liquidity while the Fed redeems securities.)

The real test of Fed leadership will come when the winning streaks for the economy and the financial markets finally run out. In a speech the Friday before last, Yellen suggested extraordinary measures such as QE and zero interest rates may be needed in the next downturn, even if it is not nearly as severe as the 2008-09 crisis.

Would a Powell-Taylor Fed do likewise? And if not, would that be better or worse? That’s the uncertainty being introduced into the current placid markets.