What to expect from the Fed under Powell

Despite a few setbacks and persistent apprehensions on inflation, during her tenure the Fed has started a gradual process of policy normalisation.

Since December 2015, the Fed has hiked rates five times, and more recently, it has laid out a plan for a gradual unwinding of its large balance sheet.

Her successor, Jerome Powell, will inherit the challenge to strike the right balance for policies in a context of elusive inflation and growing financial stability concerns.

Safe pair of hands

At first glance, Mr Powell is a safe pair of hands, well positioned to grant continuity to the Fed’s policy course. During his time as Federal Reserve governor, he has been largely aligned to the Federal Open Market Committee (FOMC) leadership.

While he initially expressed some scepticism on the last QE programme, he eventually supported it in 2012, and in recent years he has been on board with the Fed’s cautious approach to policy normalisation, based on gradualism and data-dependency.

Unlike his predecessors, Ben Bernanke and Ms Yellen, Powell has a legal background rather than an economic degree.

While Mr Powell is unlikely to deliver surprises on his own, the overall dramatic evolution of the FOMC around him is a significant source of uncertainty.

This fact has probably led him to rely more heavily on monetary policy analysis carried out by the Fed’s staff, and it has contributed to the perception he has a largely neutral policy bias.

Going forward, he is likely to follow in Ms Yellen’s steps by adhering to the prevailing analytical and operational framework for monetary policy, and by adopting a constructive approach to consensus building.

On the regulatory side, he seems more open to some softening of existing regulations for small and medium banks compared to his predecessor, but he is unlikely to support a radical overhaul of the Dodd-Frank construct.

Source of uncertainty

Changes in the FOMC beyond the chairman are probably more relevant.

While Mr Powell is unlikely to deliver surprises on his own, the overall dramatic evolution of the FOMC around him is a significant source of uncertainty.

Come February 2018, more than half of the board of governors will have changed compared to a year earlier, and over the remainder of the year, President Donald Trump will have the chance to appoint up to three additional members.

In addition, there will be significant change affecting the Federal Reserve Banks, with the very influential New York Fed’s President Dudley leaving in June. 

This turnover makes it hard to fathom the bias of the FOMC going forward. While at face value changes imply a more hawkish FOMC composition, it looks unlikely that in the short term the new FOMC will diverge from the existing policy course, already following a normalising trajectory.

Provided the outlook evolves as expected, the Fed will deliver on the three rate hikes it signalled for 2018.

The inflation question

At the same time, the gradual reduction of its balance sheet is almost on autopilot, providing additional tightening equivalent to 130 basis points of further rate hikes by the end of 2019.

Medium-term implications from changes in the composition of the FOMC could be potentially more significant, especially at a time when traditional models used in central banks seem to falter.

The puzzle of missing inflation has put into question the ability by central banks to meet their targets, triggering a debate on how the monetary policy framework should evolve.

While the debate is currently revolving around the opportunity of adopting higher inflation targets or a price level targeting approach, the arrival of new members with different backgrounds could shift the focus on different aspects.

Notably, there might be more emphasis on a rule-based approach, à la Stanford University economist John Taylor - at one time a frontrunner to replace Ms Yellen - and on financial stability issues.

Silvia Dall'Angelo is senior economist at Hermes Investment Management