November 3, 2017
Adrian Cronje, Ph.D., CFA
Chief Investment Officer, Balentine
We have been flagging the potentially significant implications of a new Federal Reserve (Fed) chair for a while, but markets greeted yesterday’s announcement that the Trump Administration will appoint Jerome “Jay” Powell when Janet Yellen’s term expires early next year with a gaping yawn. Instead, markets remain more focused on the improving fundamentals that have driven up the economy and markets all year, along with the probability of successfully passing tax reform. Of course, as the Fed chair is one of the world’s most powerful economic figures, there has been no shortage of media coverage surrounding this announcement.
As many have been quick to point out, Powell’s appointment is notable for several superficial reasons. First, President Trump has broken with recent precedent, as this is the first time since the 1970s that an available incumbent has not been reappointed: Paul Volcker was appointed by Jimmy Carter and reappointed by Ronald Reagan; Alan Greenspan was appointed by Reagan and reappointed by Bill Clinton; Ben Bernanke was appointed by George W. Bush and reappointed by Barack Obama. This is also the first time since then that the chairman will not have a Ph.D. in economics.
However, taking a step back from all of this noise, Powell’s appointment does reflect a very rational decision for the Trump Administration given their agenda. On the one hand, they want to see continuity in the current “dovish” monetary policy stance of raising interest rates slowly, gently, and predictably. On the other hand, they want a Federal Reserve that has a lighter touch when it comes to bank regulation. Janet Yellen checked the first, but not the second box. While viewed favorably on the issue of regulation, the administration worried that the other two leading candidates for the job, John Taylor and Kevin Warsh, would be too “hawkish.”
Enter Jerome Powell, a current Fed board governor and consummate insider who has been at the Yellen Fed since 2012. Having never once dissented against the Fed’s decisions since then, he is a supporter of the current monetary policy stance, and, as a lawyer and businessman by trade with a keen interest in banking regulation and capital market liquidity (two major issues the Fed faces in the coming years), it is hoped that he will fit the bill perfectly.
Like his predecessors, Powell is likely to face significant and unforeseen challenges during his tenure. Over lunch last week, I had the opportunity to hear and ask former Fed Chair Dr. Ben Bernanke’s perspective on this given current economic conditions:
Leadership of the Fed
When asked who he would like to see lead the Fed, Dr. Bernanke said that Janet Yellen deserved to be reappointed. He pointed out her long tenure and deep experience as a policy maker, as well as her successful guidance of the initial normalization of monetary policy from the emergency conditions in the immediate aftermath of the Great Financial Crisis.
The State of the Economy
Dr. Bernanke believes that the economy is in a much better place now than it was two years ago when the Fed’s efforts to begin normalizing monetary policy were short circuited by a strong dollar and global economic weakness abroad. Today’s global economy is growing in a synchronized manner, clearing the path for a continued, steady normalization of interest rates through 2018, even if the terminal Fed funds interest rate is lower than before, at around 2.5%. At the same time, the Fed will continue to unwind its balance sheet, even if that, too, does not fall all the way back to the pre-Crisis level of below $1 trillion.
Lessons from the Financial Crisis
According to Dr. Bernanke, the biggest lesson learned from the Financial Crisis was that unconventional monetary policy techniques (i.e., “quantitative easing” and “forward guidance”) worked. They created the conditions for the economy to recover and for unemployment to fall, and they did not stoke hyper-inflation or a collapse in the U.S. dollar, as many feared at the time. When the Bank of Japan and European Central Bank aggressively employed these unconventional techniques in recent years, their economies started to turn around, as well. However, he has a concern that these unconventional measures will now become a normal part of the monetary policy playbook and, should the global economy face another downturn, there would not be enough cushion to use conventional measures (e.g., lowering interest rates) to stabilize it.
While Dr. Bernanke acknowledged that valuations on stock markets were high by historic standards, that, in and of itself, was not a concern to him. More concerning is when high valuations are underpinned by high and unsustainable levels of leverage, leading to potentially unstable financial circumstances. He admitted that the mistake the Fed made was that they were not early enough to see the high levels of leverage in the system before the Great Financial Crisis.
His Biggest Regret
When asked, Dr. Bernanke said that his biggest regret about the way in which the Fed handled the Crisis was its inability to explain in clear, simple terms what they did and why it was necessary. Although he introduced regular press conferences and even appeared twice on 60 Minutes, his attempts to explain the Fed’s actions in plain terms to Main Street were unsuccessful. Many still feel like the Fed was “captured” by Wall Street to serve their own interests by bailing out the reckless and greedy behavior of banks. His contention remains that the Fed had to secure the banking system so that the economy would avoid a depression before they could turn their attention to making it more financially stable through more effective regulation.
This lack of understanding was a key source of the anger and disenfranchisement that has turned into the pervasive populist outcry across the developed world today. He worries that should the Fed need to use unconventional monetary policy methods again in the future, the average American won’t be “on board” and that the independent Fed may be politicized. He is also very concerned that this populism may lead to economic isolationism, in which global trade deals are not improved, but are abandoned altogether, undermining global economic growth.
China’s Credit Bubble
Ending on a positive note, Dr. Bernanke did paint a positive picture about developments abroad, particularly as it relates to China. Though there are widespread concerns about a Chinese credit bubble, he explained that much of their debt is financed locally rather than from fickle foreign investors. Ultimately, this gives China a greater ability than people may anticipate to pursue the political reforms that are necessary for the market forces to take a greater role in driving and sustaining Chinese growth in the future.
 Congress announced the blue-print of their tax reform plan yesterday, and we will be analyzing its implications thoroughly in an upcoming blog.