2017-03-23 08:46:42
Donald Trump has the chance to mould America s central bank
THIRD time lucky. In each of the past two years, the Federal Reserve has
predicted multiple interest-rate rises, only to be thrown off-course by events.
On March 15th the central bank raised its benchmark Federal Funds rate for the
third time since the financial crisis, to a range of 0.75-1%. This was, if
anything, ahead of its forecast, which it reaffirmed, that rates would rise
three times in 2017. Lift-off is at last an apt metaphor for monetary policy.
But as Janet Yellen, the Fed s chairwoman, picks up speed in terms of policy,
she must navigate a cloudy political outlook. The next year will define her
legacy.
Ms Yellen took office in February 2014 after dithering by the Obama
administration over a choice between her and Larry Summers, a former treasury
secretary. Left-wingers preferred Ms Yellen, in part because she seemed more
likely to give jobs priority over stable prices. Indeed, Republicans in
Congress worried that she would be too soft on inflation. The Economist called
her the first acknowledged dove to lead the central bank.
Today Ms Yellen looks more hawkish certainly than Mr Summers, who regularly
urges the Fed to keep rates low. Headline inflation has risen to 1.9% a year;
but excluding volatile food and energy prices it is a bit stuck, at around
1.7%. Yet Ms Yellen has not really changed her plumage. As expected, she has
consistently given high weight to unemployment. Before her appointment, when
joblessness was high, she wanted the Fed to promise to keep rates low for
longer than it then planned. Now that unemployment is just 4.7%, she is keener
to raise rates than those who worry about stubbornly low inflation.
In March 2015 Ms Yellen argued that, were the Fed to ignore a tight labour
market, inflation would eventually overshoot its 2% target. The Fed might then
need to raise rates sharply to bring it back down, risking a recession and
hence more unemployment. Better to lift rates in advance.
Unemployment, however, was already down to 5.5%. So most rate-setters had
started 2015 forecasting a rapid lift-off, taking rates up by at least one
percentage point over the year. But inflation remained strangely tepid (see
chart). Cheap oil and a strong dollar were partly to blame. But wages also
seemed stuck. Ms Yellen and her colleagues deduced that unemployment could
safely fall a bit further.
In the end, they raised rates once in 2015, in December. Again, they forecast
four rate rises for the next year. This time they were delayed by worries over
the global economy (China wobbled early in 2016). Officials also began to see
lower rates as a permanent feature of the economy. Today, the setters think
rates will eventually stabilise at 3%, down from a forecast of 4% when Ms
Yellen took office.
Ms Yellen s Fed, then, has proved very willing to change course. And this time
the Fed is speeding up, rather than postponing, rate rises. Three factors are
at play. First, the global economy has been reflating since the middle of 2016
(see article). Second, financial markets are booming, boosting the economy by
almost as much as three interest-rate cuts, by some estimates. Third, a fiscal
stimulus is looming. According to the Fed s model, a tax cut worth 1% of GDP
would push up interest rates by nearly half a percentage point. During his
campaign Donald Trump promised cuts worth nearly 3% of GDP, according to the
Tax Policy Centre, a think-tank.
Doves insist that the Fed risks halting an incomplete recovery. Before the
crisis of 2007-08, about 80% of 25-to 54-year-olds (the prime age population)
had jobs. Today the proportion is 78%. The difference is about 2.5m potential
workers, mostly not counted as unemployed because they are not looking for
work. Were the Fed to aim for the nearly 82% prime-age employment seen in April
2000, the jobs shortfall would look twice as high.
In October Ms Yellen wondered aloud whether a high-pressure economy , and a
resulting wage boom, might coax more people to seek work. This led to reports
soon corrected that she would let the economy overheat after all. In fact Ms
Yellen has long warned that many drivers of labour-force participation are
beyond the central bank s control. A gentle pickup in wage growth since
mid-2015 seems to support her view that unemployment is the best measure of
economic slack.
Rarely has unemployment been this low without inflation taking off. Once was in
the late 1990s, when Alan Greenspan, a former Fed chairman, correctly predicted
that rising productivity would stop a booming labour market from stoking
inflation. Jeffrey Lacker, chairman of the Richmond Fed, recently offered
another example. In 1965 unemployment fell to 4%, while inflation was only
1.5%. Yet prices took off in the years that followed: by 1968, inflation had
reached 4.3%.
That is what Ms Yellen wants to avoid. But the Fed has not often managed to
tighten monetary policy without an ensuing recession. Should she manage it, her
tenure will go down as a great success.
That is, if she has time to finish the job. Her term ends in February 2018. If
Mr Trump replaces her, she could stay on as a board member. But she would
probably leave. So would Stanley Fischer, the Fed s vice-chairman, whose term
expires four months later. Two of the Fed s seven seats are already vacant, and
Daniel Tarullo, the de facto vice-chairman for regulation, goes in April. So Mr
Trump may be able to appoint five governors, including the chairman, within 18
months of taking office.
What then for monetary policy, and for Ms Yellen s legacy? During his campaign,
the president attacked the Fed for keeping rates low and said he would replace
Ms Yellen with a Republican. Mooted successors include Glenn Hubbard, who
advised George W. Bush; Kevin Warsh, a former banker and Fed governor; and John
Taylor, an academic and author of a rule, named after him, for setting interest
rates.
A kettle of hawks
All these potential successors are monetary-policy hawks. Some versions of the
Taylor rule, for example, call for interest rates more than three times as high
as today s. Mr Trump, who promises revival and 3.5-4% economic growth, might
not like the sound of that. If, like most populists, he wants to avoid tight
money, he could appoint someone malleable to the Fed. But that would also be
risky. One cause of the inflationary surge of the 1960s, notes Mr Lacker, was
political pressure to keep policy loose even after ill-timed tax cuts. On one
occasion, President Lyndon Johnson summoned the Fed chairman, William McChesney
Martin, to berate him for raising interest rates (and to drive him around his
ranch at breakneck speed).
A simpler way to keep hawkish Republicans at bay would be to reappoint Ms
Yellen. With Mr Tarullo out of the frame, Mr Trump would still be able to
impose his deregulatory agenda, yet keep faith with Ms Yellen to set monetary
policy. Senators would struggle to come up with reasons not to reappoint a
central-bank chairwoman so close to achieving her goals. Bill Clinton and
Barack Obama reappointed incumbent Republican chairmen. It might be in Mr Trump
s interest to reciprocate.