Market Analysis: Policy continuity amid changing of the guards at US Federal Reserve
The US president Donald Trump has officially nominated Jerome Powell, to be the next chairman of the Federal Reserve, replacing Janet Yellen when her term expires on February 1, 2018.
Jerome Powell is a lawyer rather than an academically trained economist and would be the first chairman without an economic doctorate since Paul Volcker served from 1979 to 1987. The majority of his other experience has been in investment banking and private equity. He joined Fed board of governors in 2012 and therefore was involved in the decision-making behind QE3 and policy normalisation in recent years.
Mr Powell may not have the depth of economic expertise expected by the market but that is unlikely to matter for now, while the waters are relatively calm and the course of Fed’s policy is well-set. Will he emerge as a capable and strong leader when the cycle turns and the Federal Open Market Committee (FOMC) has to change course is still some way off. His senate nomination hearing in the coming months will provide the first insight into what type of Fed chairman he will be. Regardless of his performance at the hearing, however, his nomination is expected to be confirmed without too much drama.
So what can change on monetary policy?
We have no expectations that the change of Fed chairmanship in February next year will trigger any change in the monetary policy regime and expect that the UST (United States Treasury) curve will remain hinged against the improving economic growth in the US.
From the market perspective, Mr Powell’s nomination represents continuity, given his reputation as a centrist on the monetary policy spectrum, aligning his views with that of the consensus. In fact, in past speeches he has often referenced how the committee thinks rather than what he thinks. We expect a Powell-led Fed to stick with the current narrative of structurally lower growth and interest rates. However, a lot still depends on who Mr Trump picks to fill the other vacancies on the Fed’s board. With Mr Powell’s promotion, there will be four vacancies, including for the vice chairman position.
Beside an unchanged path of rate hikes in the immediate term, it will be interesting to see if a Powell-led Fed changes its view on long-term rates and therefore the terminal rate in this hiking cycle. The Fed, in its September meeting, marked down estimates to 2.75 per cent for long-run interest rates. In contrast, markets have been convinced for some time that the terminal rate in this cycle will be considerably below prior hiking cycles and will probably peak at only 2 per cent.
The Fed’s recent downward revision to long-term rates was accompanied by estimate of GDP growth declining to 1.8 per cent. However, if tax reform passes, the effect of transitory factors recede and progress is made on financial deregulation, then a pick-up in inflation expectations and higher structural rates could become a possibility. That said, these changes are more likely to be driven by uptick in economic data than on any material shift in the personalities at the FOMC.
The seemingly endless flattening in the UST curve has continued post the Powell nomination. 10-year UST yields are at only 2.32 per cent. Expectations of a reduction in growth and economic activity in the medium term, together with a global demand for yield has kept a lid on the 10-year UST yields despite the projected Fed rate hike cycle. The 2yr/10yr spread at 0.67 per cent is at nearly a decade low as the hiking cycle has bumped up the front end more so than the increase in 10yr yields resulting in this bear flattening. Weaker realised inflation from structural and idiosyncratic factors and now the continued tightening policy of the Fed is likely to keep inflation expectations low regardless of the change in leadershi[p.
What can change on balance sheet normalisation?
We expect the Powell-led Fed to proceed with the current balance sheet normalisation schedule. The latest FOMC meeting minutes showed no change in language around the balance sheet unwind that was announced at the September meeting and began in October. The FOMC wants to keep the balance sheet run-off on autopilot and markets have taken the start of the process in stride. There appears no need to deviate from this schedule in any way and the Mr Powell will need overwhelming urgency to justify any change, which isn’t the current base case.
What can change on regulation?
While Mr Powell is unlikely to change the path of Fed’s policy in the short term, he will probably put significant priority on scaling back financial market regulation. In recent speeches, he has stated: “There is certainly a role for regulation, but regulation should always take into account the impact that it has on markets, a balance that must be constantly weighed. More regulation is not the best answer to every problem.”
We think he will work towards easing some of the burdensome regulations albeit with the goal of retaining the core post-crisis policies. He had recently highlighted the main points for possible regulatory reforms as follows: simplification of regulation of small and medium-sized banks; reassessing the Volcker Rule with possibility of eliminating or relaxing aspects of the rule; comprehensive capital analysis and review – enhance transparency around how this is assessed; supplementary leverage ratio – examine the relative calibrations of the leverage ratio and the risk-based capital requirements.
Mr Powell is likely to make these adjustments soon after the appropriate due diligence has been conducted.
Anita Yadav is the Vice-Chair of the Gulf Bond and Sukuk Association as well as the Head of Fixed Income Research, Senior Director – Wholesale Banking at Emirates NBD Bank.