Dr. Janet Yellen’s term as Chair of the Board of Governors of the Federal Reserve (Fed) System ends in early 2018. While she could be reappointed for another four-year term as Chair, reading the tea leaves in Washington D.C. suggests a scenario where we may see a person from a business career take over the gavel. And not just as Chair. There are three vacancies on the Board of Governors, and we also expect a new Vice-Chair in the summer of 2018. That is, there is a potential for five new board members on a seven-member board, and some or all of those seats could be filled with business-career credentialed individuals instead of persons with academic or central bank experience. This could usher in a major cultural change at the Fed. Such a cultural shift might make a very big difference in how decisions about interest rate policy may be made.
Our intuition is that more business experience on the Fed Board of Governors and fewer economists will shift the debate away from academic interpretations of monetary policy and increase the focus on the interplay of rates and debt. More specifically, the high debt loads in the U.S. will create a bias for lower than otherwise rates, so that increases in debt-service expenses do not derail an economic recovery. Over the long haul, if this scenario prevails, a bias toward lower rates relative to inflation is likely to also lead to a weaker trend for the U.S. dollar as well.
Before the economists – the battle for an independent Fed
Economists have been running the Fed since 1970, when Professor Arthur Burn of Columbia University was appointed Chairman of the Board. Our story of how the Fed might change as the pendulum swings away from economists, however, needs the context and historical background of how the Fed was managed in its early days. Indeed, men of business and banking experience were largely responsible for fighting for and winning the relative independence the Fed gained after WWII.
The Federal Reserve Act of 1913 created the institution. However, big changes came with the Banking Act of 1935. The Fed had effectively failed in itsoriginal mission to serve as a lender of last resort. Indeed, much of the blame for the stock market crash of 1929 spiraling into the Great Depression is credited to the Fed closing banks instead of providing loans and liquidity to prevent runs on banks. So, a big change in governance was in order. At the creation of the Fed, the regional bank heads (then called Governors, and Presidents after 1935), especially the head of the Federal Reserve Bank of New York, held most of the power.
During the 1920s, the Fed was effectively run by Benjamin Strong Jr., the first Governor of the Federal Reserve Bank of New York. Strong had risen through the ranks of bankers and become President of Bankers Trust before moving to the newly-created Federal Reserve Bank of New York. Unfortunately, Governor Strong passed away in October 1928, creating a lack of leadership and a huge power vacuum at the Fed when the stock market crashed in the fall of 1929. Without the effective leadership of Strong, the Fed was unable to build a consensus to take the emergency actions needed to stop runs on banks, and backstop the financial system.
With the Banking Act of 1935, the power of regional Fed bank heads was greatly diminished in favor of a powerful Board of Governors based in Washington. In 1936, President Franklin D. Roosevelt appointed Mr. Marriner Eccles as the first Chair of the new Board of Governors of the Federal Reserve System. Roosevelt continued to reappoint him every four years during his Presidency. Eccles was a highly successful banker, creating and running Eccles-Browning Affiliated Banks, which managed to survive the Great Depression and burnished Mr. Eccles’ credentials.
As the U.S. emerged from the Great Depression, the key challenge was how to finance WWII. To help finance the huge debt load required to pay for the war, the U.S. Treasury and Fed reached an agreement to hold the interest rate on U.S. Treasury bills at 0.375%. After the war, as millions of soldiers returned to civilian life, the economy went into recession and inflation surged. Eccles, as Chair of the Board of Governors, opposed continuing the low-rate agreement and argued for a more independent Fed. President Harry S. Truman reacted by appointing a new Chair, Thomas B. McCabe. Eccles’ term of office as a board member had not expired, and he stayed on the board and actively worked to secure a more independent Fed that would not be obligated to monetize the large debts incurred from WWII. The debate was quite acrimonious and was a major distraction for Truman. Indeed, Truman called a meeting at the White House of the whole Federal Open Market Committee (FOMC) to work out a compromise with the U.S. Treasury. The end result was the “1951 Accord,” which restored the independence of the Fed.
Immediately after the Accord was reached, William McChesney Martin, then Assistant Secretary of the Treasury, a key power broker in the compromise, was named the Chair of the now more powerful and independent Board of Governors of the Federal Reserve System. Martin was a classic liberal arts student with stellar financial market experience. Mr. Martin graduated from Yale where he studied English literature and Latin. He did have Fed blood in his veins. President Woodrow Wilson had asked Martin’s father to help draft the Federal Reserve Act of 1913 that created the institution, and the elder Martin also later served as head of the Federal Reserve Bank of St. Louis. The younger Martin was a stock broker, owned a seat of the New York Stock Exchange and later served as its President, before being appointed in 1951 as Fed Chair. Mr. Martin served under five Presidents – Truman, Eisenhower, Kennedy, Johnson, and Nixon – and built a strong tradition of an independent Fed.
Era of economists arrives in 1970
Professor Arthur F. Burns, from Columbia University, was appointed as Chair of the Fed by President Richard M. Nixon in 1970. Then, there was a brief intermission as a businessman, G. William Miller, was Chair of the Fed from March 8, 1978 through August 6, 1979, after which Paul Volcker was appointed by President Carter. Volcker had studied political economy at Princeton and did graduate work at Harvard and the London School of Economics. While not a professor of economics, Volcker was well steeped in the logic of economics and its application to monetary policy. Dr. Alan Greenspan followed Volker in 1987, with a strong focus on the practical aspects of economic forecasting. Then, in 2006, President Bush appointed Professor Benjamin Bernanke, who had studied at MIT and taught at Princeton. And, now we have Dr. Yellen, an expert in labor economics at the helm of the Fed, and incidentally, married to a Nobel Laureate in Economics. From the perspective of history, economists have had a very mixed track record at the Fed. And, for the record, as a professional economist and quantitative analyst, I would not take personally this potential swing of the pendulum away from economists.
The expansion of the money supply under Chair Burns gets partial credit for allowing inflation to take hold in the 1970s. The Volcker-Fed had to push rates to 20% to create a deep recession and drive inflation back down.
Dr. Greenspan lowered rates after the stock market crash of October 1987 and then pushed them sharply higher in 1989, helping to precipitate the Savings & Loan Crisis and a recession. The rapid reversal in rates and the subsequent rate hikes in the spring of 1994 helped trigger a massive bear market in government bonds around the world. Dr. Greenspan also lowered rates after the 9-11 terrorist attacks and the stock market tech wreck. In hindsight, the Greenspan-Fed probably kept rates much too low for too long, and helped create the housing boom, which went bust after he pushed Federal Funds rates higher, from 1% to 5.25% in 17 quarter-percentage-point steps from 2004 to 2006.
The financial panic of September 2008 came under Bernanke’s watch with the very messy bankruptcy of Lehman Brothers and bailout of AIG. Professor Bernanke followed through on his academic research into the Great Depression, and he used the Fed’s balance sheet to purchase distressed assets, helping to prevent the recession from turning into a depression. His later moves into Quantitative Easing (QE) involved purchases of U.S. Treasuries and mortgage-backed securities, while the economy was already growing. The Bernanke-Fed experiment with unconventional monetary policy during a period where solid private sector job creation worked to raise asset prices and lower bond yields, but did not work as hoped to increase real GDP growth or inflation.
The task of moving rates back upward fell to the Yellen-Fed. Chair Yellen currently is leading an interesting debate within the Fed about what would constitute a “neutral” interest rate policy. Her position appears to be that in the current context, a neutral policy, neither tight nor accommodative, would be when the Federal Funds rate is more or less equal to the core inflation rate – the Fed’s target for the core inflation rate is 2%. So, after the November 2016 election, the Yellen-Fed raised rates in December 2016 and again in March 2017, with a clear message that rates were headed toward a “neutral” policy stance down the road.
Historians will no doubt write and rewrite the story of the Fed. When we look back at the question of the Fed’s political independence, which the bankers and businessmen fought hard to achieve back in 1951, the era of economists has a mixed record. No one is going to accuse the Volcker-Fed of pushing short-term rates to 20% to help President Carter get re-elected. And by the same token, no political motives are likely to be ascribed to the Greenspan-Fed’s potential guilt related to the S&L crisis of 1990 and the sub-prime mortgage crisis of 2007-2008 for raising rates too fast and not appreciating the financial risks inside the banking system that the Fed was supposed to be monitoring.
On the other side of the ledger, the Burns-Fed and the Yellen-Fed may take some heat from historians, although these interpretations will be subject to much debate. The federal funds rate stood at 9% in February 1970 when Professor Burns was appointed, and he had it down to 4% in the spring of 1972 as the Presidential election campaign began. The Yellen-Fed made the first quarter-point rate increase in December 2015, then took the election year off before starting a more convincing process of raising rates back to a “neutral” policy in December 2016. There were many non-political reasons for these policy decisions, so we expect history to be rewritten several times as economists argue about what drives monetary policy.
Cultural change at the Fed
Let’s be clear. The changes in the composition of the Board of Governors of the Fed may well not occur this time around. Time will tell. We are merely examining one possible scenario when suggesting that the era of economists is coming to an end. If economists continue to hold the gavel at Fed meetings, then debates about what is a “neutral” federal funds rate policy and what is the “natural” rate of unemployment will continue apace. However, as economist like to say, “on the other hand” if the pendulum swings to a more business-oriented Board of Governors, what would be the potential policy implications?
Regarding independence, academics can be surprisingly political, unless of course you have actually been a university professor and realize the devastatingly bitter politics of faculty senates. In any case, we are not worried about the Fed losing its independence, as that bridge has already been crossed during the era of economists, at least depending on which analysts you read. A business-oriented Fed may have its biases, but it is likely to work hard to defend its independence. And, it was a banker-business coalition that reached the “Accord” in 1951 that secured independence of the Fed from the US Treasury.
The nature of the internal debates may fundamentally change. As noted earlier, academics worry about things like “what is neutral” and is there an appropriate “rule” to determine interest rate policy. Business types will have a much different focus. We think business-credentialed Fed Governors will worry a lot about debt in the future. Indeed, we think high debt levels keep them awake at night. Business folks know that higher rates will make it harder to service already high debt loads. Consequently, our major intuition is that under a regime of Federal Reserve Board Governors drawn from the business world, rate hikes will come more slowly due to their fear of just how indebted the economy is – the U.S. government debt, student loans, auto loans, etc. Looking back at the rising rate policies that triggered the S&L Crisis of 1990 or the Sub-Prime Mortgage Crisis of 2007-2008, both debt-related, our perspective is that these episodes will argue for caution in raising rates. Economists might focus on a “neutral” rate policy that is determined by the level of inflation, while business-oriented individuals may simply worry about how to service the massive debt levels in the US if rates rise. If this scenario of cultural change at the Fed were to come about, one of its implications is that the era of a strong dollar may be a casualty. Heavy debt loads increase the temptation to risk higher inflation rather than worry about too strong economic growth, so this biases the Fed toward relatively more accommodative policy stances. Just food for thought, as time will tell.
End of the era of economists running the Federal Reserve?
BLU PUTNAM, CHIEF ECONOMIST AND ERIK NORLAND, SENIOR ECONOMIST, CME GROUP
Originally published in the March 2017 issue