All things considered, the main risk clouding the outlook for the US and the global economy is still the high likelihood of policy accidents for global trade. In particular, an escalation of protectionist measures would act as a supply shock, resulting in a period of higher inflation and slower growth. The Fed would probably look through a temporary surge in inflation, as the impact from slower growth would eventually prevail. Protectionist tensions are unlikely to fade anytime soon. Going forward, a more confrontational relationship between the US and China will probably become a new feature of the geopolitical landscape, and the risk of an escalation will probably re-emerge on a regular basis.
Change at the top: how new personnel will impact the existing policy framework
A more fundamental change in the Fed’s approach could stem from recent changes in its personnel. Not only did Powell replace Janet Yellen as FOMC Chair in February this year, but US President Donald Trump also appointed four new Governors: Randal Quarles, Richard Clarida, Michelle Bowman and Marvin Goodfriend. Quarles, the Fed’s vice-chairman for financial supervision, is already participating in FOMC decisions, while the soon-to-be Fed vice-chair Clarida and board members Bowman and Goodfriend are still waiting for confirmation from the US Senate. In addition, there have been few changes at regional Federal Reserve Banks. Most notably, San Francisco Fed President John Williams will replace William Dudley as New York Fed President, after the June FOMC meeting7. The position is one of the most influential for shaping monetary policy as it enjoys a permanent vote on the FOMC.
Our overall assessment is that new personnel at the Fed will preserve policy continuity in the short term – even though some have voiced hawkish views since their appointment. The new FOMC members have an orthodox attitude towards monetary policy, and they are unlikely to disrupt a normalisation plan, that has been successful thus far. Only a change in circumstances would bring about an adjustment to the policy course, which would be facilitated by the pragmatic and collegial approach of Powell.
The implications of the new FOMC composition could be potentially more significant in the medium term, especially when the debate on the evolution of the practice of monetary policy has intensified. The discussion has recently focused on how to revive the existing monetary policy framework in a context of structurally low interest rates, where the zero-lower bound is more constraining. Thus far, arguments have been made in favour of adopting higher inflation targets or a price level targeting approach (see, for instance, Williams8 and Bernanke9).
The arrival of new FOMC members with different backgrounds could shift attention to different potential evolutions of monetary policy. Notably, there might be a greater emphasis on a rule-based approach à la John Taylor, which would point to a much higher policy rate (as high as 4% assuming a 5% non-accelerating rate of unemployment (NAIRU), or closer to 3% assuming a 4% NAIRU). Moreover, some new appointees have been critical of the Fed’s unconventional monetary policy tools (notably, QE), stressing the potential unintended consequences in terms of financial stability risks.
The road ahead
Today, the Fed faces what looks like an easy task – to continue along its gradual path towards normalisation. The US economy is expanding at a solid rate, the labour market continues to improve and inflation has increased towards the 2% target. The Fed’s normalisation plan predicts two to three more hikes a year until 2020, as well as the ongoing, gradual balance sheet reduction.
However, the Fed cannot be complacent. In the short to medium term, the significant fiscal stimulus announced by the US administration, US yield curve developments, a possible overshoot of inflation and the potential escalation of protectionist threats might interfere with the normalisation process. As protectionism is probably the most significant threat, the normalisation process might turn out to be slower rather than faster.
In the longer-term, the new post-crisis regime poses a new set of challenges: lower trend growth implies that the end point for the policy rate is way below its historical average. Moreover, the Fed’s balance sheet will also remain well above pre-crisis levels. In this context, the lower bound for rates is more constraining, leaving the FOMC with limited ammunition to respond to the next crisis. A new monetary policy framework may, therefore, be warranted – and perhaps then, the new FOMC members will shape the debate.
1 “Minutes of the Federal Open Market Committee May 1–2, 2018”, published by the Fed on 23 May 2018
2 "Measuring the Natural rate of Interest", by Thomas Laubach and John Williams, published by Review of Economics and Statistics in November 2003.
3 Thomas Laubach is an economist on the Board of Governors of the Federal Reserve System. John Williams is the president of the Federal Reserve Bank of San Francisco. He will replace Bill Dudley as New York Fed president on his retirement on 17 June.
4 For a recent discussion on the drivers of r*, see “The Future Fortunes of R-star: Are They Really Rising?”, speech by John Williams, published by the Federal Reserve Bank of San Francisco on 21 May 2018
5 “The US Economic Outlook and the Implications for Monetary Policy”, by William Dudley, published by the Federal Reserve Bank of New York on 7 September 2017
6 “Minutes of the Federal Open Market Committee May 1–2, 2018”, published by the Fed on 23 May 2018
7 The FOMC Governors, the NY Fed President and four rotating President from the Regional Banks (out of a total 12) have voting status at policy meetings.
8 “Preparing for the Next Storm: Reassessing Frameworks and Strategies in a Low R-star World”, by John Williams, published by the Federal Reserve Bank of San Francisco on 8 May 2017
9 “Monetary Policy in a New Era”, by Ben Bernanke prepared for the conference on Rethinking Macroeconomic Policy, Peterson Institute, in October 2017