Changes at the Fed: What Does the Coming Personnel Shake-Up Mean? | Charles Schwab

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Changes at the Fed: What Does the Coming Personnel Shake-Up Mean?

February 21, 2017

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

President Donald Trump came to office with a policy wish list that promised to shake up the country’s financial markets. Tax cuts. A massive infrastructure spending plan. Big changes to the regulatory playbook.

Now it looks like he may also have the chance to put his stamp on the country’s monetary policy, as well.

In the coming year or so, Trump may have the opportunity to nominate at least five of the seven members of the Federal Reserve’s Board of Governors. The board plays a key role in setting the Fed’s benchmark interest rate target—which affects borrowing costs across the economy—and regulating the country’s banks.

So what could these changes mean? And how could they affect the markets? Let’s take a closer look.

Open seats

First, we should address the personnel turnover. Two seats on the board of governors have been open since 2013, as the Senate declined to hold hearings on the nominees put forward by then-President Barack Obama. Then, in mid-February, Fed Governor Daniel Tarullo, who’s responsible for overseeing bank regulation, announced that he would retire in April.

That means Trump may be able to fill three vacancies on the board within the first few months of his presidency.

And then some more big changes will come in 2018. Janet Yellen’s four-year term as the chairwoman of the board of governors will end in February 2018, and Stanley Fischer’s term as vice chairman will end just a few months later, in June 2018. Technically, both of them could choose to remain on the board for several more years, as they will continue to be Fed governors (Yellen until 2024, Fischer until 2020). By tradition, though, former chairs and vice chairs generally relinquish all of their positions on the board once their leadership terms end.

New nominee?

Theoretically, Trump could re-nominate Yellen for another term, even though she was first elevated to the post by Obama. It has been done before: Before nominating Yellen, Obama, a Democrat, asked Ben Bernanke to serve a second four-year term as Fed chair even though he was first appointed by a Republican predecessor, George W. Bush. And Alan Greenspan was nominated to serve by four different presidents: Republicans Ronald Reagan, George H.W. Bush and George W. Bush, and Democrat Bill Clinton.

However, a second Yellen term seems unlikely. Trump has indicated he is keen to replace her and has been fairly critical of her performance at the Fed. During the campaign, he also said he thought interest rates were too low.

New world

Does that mean Trump is likely to pick interest rate hawks to fill these spots?           

“So far, the administration hasn’t nominated any candidates for the open seats,” says Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research. “But some potential candidates’ names have been floated, including John Taylor, the Stanford University professor who is the creator of the so-called Taylor Rule.”

In essence, the Taylor Rule involves turning interest rate decisions over to a mathematical formula that takes account of things like inflation, employment and the country’s potential economic growth rate, instead of leaving such decisions to the judgment of individual Fed members. Advocates of this approach say it would be more transparent and predictable, which would be good for markets. Critics say it is too mechanistic and could increase volatility because interest rates might respond to real-time data that often ends up being revised.

Historical comparisons between the effective federal funds rate and the theoretical rate proposed by the Taylor Rule show that they’re generally pretty close most of the time. However, the two have diverged quite a bit in recent years as the Fed has kept rates much lower than they would be under the Taylor Rule, partly because of uncertainty about the economy. 

In any case, a Taylor nomination would actually chime with recent efforts by Congressional Republicans to push the Fed into adopting a more rules-based approach.

Rate moves

Again, it’s not clear what will happen at the Fed in the coming months. And additional interest rate hikes already appear to be on the agenda this year. By most measures, inflation is at or above the Fed’s 2% target level and trending higher, and tax cuts or increased spending under the Trump administration could add to the buzz. Recent economic readings have also shown that the economy continues to gather pace—manufacturing indicators are improving, the labor market is strong and wages should remain on an upward trajectory.

“The Fed is already on the path to raising rates two or three times this year and if new members lean more towards following a rule-based approach to setting policy, the risk appears to be to the upside,” Kathy says.

So what does this mean for investors, particularly in the bond market, where rising interest rates generally mean falling bond prices?

“We continue to expect volatility to pick up in the bond market due to the increased uncertainty about fiscal and Fed policy,” Kathy says. “We suggest bond investors continue to keep the average duration in their portfolios in the short to intermediate term.”

Uncertainty is an unavoidable part of investing. No matter what happens at the Fed, it helps to keep focused on your investing plans and ignore the noise.

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.  Supporting documentation for any claims or statistical information is available upon request.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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