The significance of the next Fed chair choice
While short-term market moves may be less dramatic than expected, profound changes are ahead for the central bank
Mohamed El-Erian
The immediate impact on markets of US President Donald Trump’s upcoming choice for the Federal Reserve may well be less dramatic than some have argued.
By contrast, the longer-term impact on the world’s most important central bank could be far more consequential.
With the president having recently indicated that he would make his choice public early next year, the focus has been on expectations that the new Fed chair will be much more willing to cut interest rates than the current one, Jay Powell.
This is particularly the case for Kevin Hassett, who has emerged as the frontrunner among the five reported shortlisted candidates and is viewed as the most dovish of them.
This has prompted some to suggest that his appointment, in particular, would risk triggering a shift in market pricing, including lower yields on shorter-term government bonds, a weaker dollar and higher inflation expectations.
That latter would widen the gap between short- and longer-term rates.
There are two reasons why such market moves, if they materialise following such an announcement (and it’s a big if), will probably prove unsustainable if based solely on the nominee, regardless of who that is.
First, markets tend to be efficient in pricing in news ahead of announcements.
Hassett has already been the consistent favourite in prediction markets, and not by a small margin.
Second, and more importantly, it will take time for any new chair to assert authority over the policy-setting Federal Open Market Committee, which has become more fractured, lacking a unifying strategic vision as it grapples with conflicting signals that threaten both sides of the central bank’s dual mandate goals — maximum employment and price stability — as well as financial stability worries.
The next chair also will inherit a committee that has been overly dependent on backward-looking data in making policy decisions.
That makes it harder to deal with some tricky questions such as what is behind the weakening of the labour market.
Furthermore, the new leader must navigate a committee with members who are sensitive to any allegation of succumbing to political pressure and may resist even a determined new chair.
All this suggests that the immediate market impact of the appointment could be less than many anticipate.
The longer-term impact, however, could be profound.
All shortlisted candidates appear acutely aware of the urgent need to reform the Fed — an institution that, in recent years, has stumbled in its analysis, forecasting, policy implementation and communication.
The recent whipsawing expectations for this week’s policy meeting on Wednesday are not the hallmark of a well-anchored policy framework or effective forward guidance on policy.
The reputational damage has been compounded by governance issues, including claims of financial impropriety against several officials in recent years, even though some of the alleged activity was not found to have broken laws and others have been unproven.
Consequently, the Fed has become more vulnerable to political attacks from both the left and the right.
A Gallup poll in October found that only 9 per cent of Americans deemed the Fed to be doing an “excellent” job compared with 27 per cent who gave it a “poor” rating and 35 per cent an “only fair” one.
The next chair must pursue reforms that strengthen the Fed’s performance and thus safeguard its independence.
The required list is long. It includes the way the Fed’s inflation target is specified and altering its “dot plot” publication showing rate expectations of policymakers and other communication practices.
It also needs to update balance sheet management, enhance accountability, strengthen the central bank’s compliance culture and more generally challenge groupthink.
It also requires a pivot from an obsession with management of demand in the economy to pay greater attention also to supply-side developments.
After all, we are living through a period of significant structural change — from the fragmentation of the global economic order to the rise of AI — that backward-looking Fed models have not and cannot adequately address.
These are the changes that will make a durable difference to the American economy.
If the new chair can move the Fed forward on them, they will have done something far more valuable than simply cutting rates.
They will have restored the effectiveness and credibility of an institution that is critically needed to help guide the economy through changing times.
The writer is the Rene M Kern professor of practice at Wharton School, chief economic adviser at Allianz and chair of Gramercy Funds Management
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