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Abu Dhabi, UAEMonday 18 June 2018

US Fed chairman candidate Taylor a complex proposition

Questions over how successful would he be as a consensus builder and leader

John Taylor may find a need to compromise if he becomes the next Federal Reserve chairman. Ted S Warren/AP
John Taylor may find a need to compromise if he becomes the next Federal Reserve chairman. Ted S Warren/AP

John Taylor has a complicated history with the US Federal Reserve that could force him into a hard pivot if he is selected as its next leader.

The Stanford University economist, who is on the US president Donald Trump’s short list to lead the central bank, wrote the monetary policy rule that Fed officials use as a constant reference, and many of the institution’s own economists are schooled in his ideas. On the other hand, he has been a vocal critic of recent Fed policy, arguing that the institution should stick closer to the recommendations of his formula and be less discretionary in its policy setting.

Mr Taylor would not be able to force an about-face overnight if he were Mr Trump’s pick. The chair has only one vote on policy, and since the former chairman Ben Bernanke’s time at the helm, consensus has been the standard for decision-making. The current crop of central bankers generally reject Mr Taylor’s world view as too rigid. That means as chairman, Mr Taylor would likely have to compromise, coax and work within the existing, discretionary framework - something of a U-turn for a man who is one of its leading critics.

“Whoever is the next Fed chair is going to have to work collaboratively,” says Tony Fratto, a managing partner at Hamilton Place Strategies in Washington and a former US Treasury department official who worked closely with Mr Taylor for several years. Of Mr Taylor, he says, “Can he do it? Yes, I think he can do it. But I also think there’s no choice but to do it.”

Mr Trump told Fox Business that he is considering Mr Taylor, The Federal Reserve governor Jerome Powell, the current chairman Janet Yellen and a “couple of others” to lead the central bank. Ms Yellen’s term expires in February. “I will make my decision very shortly,” Mr Trump said.

Mr Taylor, a frequent witness on Fed policy at the House Financial Services Committee, has mocked the Fed’s mortgage bond purchases as “mondustrial policy”, and as early as 2009 warned that the “enormous” increase in bank reserves would stoke too much inflation, a worry that has not materialised.

Before Ms Yellen, all three previous Fed chairs were reappointed by a president of another party, giving incumbents an advantage in their second term. For that reason, challengers position themselves as discontinuity candidates, says Sarah Binder, a senior fellow at the Brookings Institution and the co-author of a new book on the Fed’s relationship with Congress.

The Fed “is being treated as a political institution, not that different than other institutions”, Ms Binder says, adding that self-styled change candidates are running against the insiders.

That could play well in a White House that has appointed critics of agencies to lead them, such as Scott Pruitt, the current administrator of the environmental protection agency. Some Republicans on the senate banking committee, which has Fed oversight authority, have voiced a clear preference for getting rid of Ms Yellen. Mike Crapo, the Idaho Republican who chairs the senate panel, said last week he “disagreed” with Fed policies such as quantitative easing and wants the central bank to “change direction”.

Mr Taylor has advocated for use of prescriptive policy rules in the wake of the financial crisis, like the one he set out in 1993. It now bears his name.

“World monetary policy now seems to have moved into a strategy-free zone," he wrote in 2015. In the same paper, he supported Republican-backed legislation requiring the Fed to adopt rule-based policy making that would have it explain any deviation to policymakers.

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Mr Taylor “has supported just about every Fed reform proposal by House Republicans, to the displeasure of, I expect, everyone inside” the Fed system, says the former Fed governor Laurence Meyer, who now runs a policy research firm. “That raises the question of how successful would he be as a consensus builder and leader within the FOMC."

Fed policymakers regularly argue that subjecting the Fed to a rule - and forcing it to explain deviations to Congress - would curb independence and hurt the economy.

What is more, the rule, depending on the economic assumptions that are plugged into it, might call for several rate hikes: the baseline Taylor Rule model indicates policy rates around 3.75 per cent, versus the Fed’s current target range of 1 per cent to 1.25 per cent.

The Fed has deviated sharply from its suggested path in recent years as the post-recession economy has struggled to gain steam. It is not clear whether Mr Taylor would want to push rates up immediately, or whether he would stick to the gradual path of increases the Fed is already treading.

He indicated a willingness to be pragmatic during remarks at an October 13 conference hosted by the Federal Reserve Bank of Boston president Eric Rosengren. For his part, Mr Rosengren says “most people who end up being the chair, no matter who they are, tend to be a little bit more flexible in their thinking when they’re actually making the decision”.

One reason to diverge from the recommendations of the rule is that it would have been a poor guide during the financial crisis.

Policy was in a bind when officials cut rates to zero in 2008 following the collapse of investment bank Lehman Brothers. The Taylor rule would have recommended dipping into negative territory during the recession, but policymakers worried that would harm the nation’s banks and cause a damaging public and political backlash.

Since 2012, applying the rule would have called for higher rates than the Fed has actually set - arguably a wrong approach, since inflation has lagged and is still well under its 2 per cent target.

To be fair, Mr Taylor has always said his rule is a guideline, not a mechanical tool, and so the Fed could deviate from its prescriptions. They would just need a good reason to do so.

The Fed already looks at rules, but to formalise that process by tying policy explicitly to one would be a major change, says Peter Conti-Brown, a Fed historian at the University of Pennsylvania’s Wharton School.

“It’s about the creation of a new consensus, and I don’t know that he has the skill-set to accomplish this,” Mr Conti-Brown says.

“John Taylor could be one of the most disruptive Fed chairs in its history, if he can persuade the internal actors within the system that all this time, he was right, and they were wrong.”