Question Over Next Chair of the US Fed is Now the Dollar's Kingmaker

The question mark over who will lead the US central bank from 2018 is now kingmaker for the US Dollar. Here’s what the debate and each of the respective candidates could mean for Pound-to-Dollar buyers. 

Federal Reserve rate setters are in focus Friday given a poorer than expected set of September inflation numbers and the potential for them to influence December’s interest rate decision.

But it’s the question mark over who will lead the US central bank from 2018 that is now kingmaker for the US Dollar. 

February’s possible changeover at the top of the Fed is a many horse race and as the odds of the various relative doves and hawks fluctuate over the coming weeks and months, so too will the value of the US Dollar. Doves are those who favour lower interest rates while hawks are those who favour higher rates. 

“We would not be surprised to see the major FX rates continue to trade in a holding pattern until President Trump announces his pick to become the next Fed Chair. The announcement could dominate FX market performance heading into year end,” says Lee Hardman, a currency analyst with Japan’s MUFG.

The Fed Chair is not only responsible for the oversight of the Federal system of regional supervisory banks but also leads the discussion around US monetary policy on the Federal Open Market Committee of rate setters.

“The Fed fund futures curve signals that the market is sceptical that the Fed will raise rates beyond 2.00% in the current tightening cycle,” says Hardman.

Incumbent Fed chair Janet Yellen’s four year term expires in February and it falls to President Donald Trump to nominate a candidate to lead the central bank for the next four years.

"President Trump’s nomination has the potential to materially alter market expectations over the outlook for Fed policy in the coming years," says MUFG’s Hardman. “It is one of the key reasons why the outlook for Fed policy is subject to a heightened state of uncertainty at the current juncture.”

Meet The Candidates:

While Janet Yellen is in with a shot at renomination it is possible, likely even, that Trump may want to nominate his own candidate.

“The re-appointment of the incumbent Fed Chair would be normal for an incoming President, but it has been notable that President Trump has previously stated that he thinks it is appropriate to have someone who is a Republican,” says Hardman.

Trump has recently praised Yellen’s stewardship of the Federal Reserve however, the Republican Party has been very critical of Fed monetary policy since the financial crisis. It is unclear whether this will translate into internal party pressure for Trump to replace Yellen.

“We see some chance that Yellen could get a second term as Fed chair. Recall that earlier this year Trump was quoted as saying: “I like [Yellen’s] demeanor. I think she’s done a good job.... I’d like to see rates stay low. She’s historically been a low interest-rate-person,” says Michael Hanson, a strategist at TD Securities.

Fed Chair Janet Yellen (Above). Source: Federal Reserve Gallery.

Republicans were also highly critical of the “Obamacare” program, winning widespread support from pledges to repeal affordable care legislation, as well as making it a big part of the 2016 general election policy platform that helped them take control of both the US senate and congress.

Since gaining control of both houses of government, Republicans have passed up multiple opportunities to take action on the subject of “Obamacare” policy, forcing the White House to resort to using an executive order to shake up the field in October.

Regardless of Yellen’s prospects, there is a shortlist kicking around in the hands of reporters that has got markets moving.

“We see the gyrations of the market on the likely hawkishness of the new Chair as exaggerated, as we will not have a complete picture without knowing the complete composition of the board, and the Vice Chair’s stance in particular,” says Barclays analyst Juan Prada.

The Fed Vice Chair position is also vacant for 2018 onward, as well as several seats on the broader FOMC panel, all of which merely adds to the uncertainty around Fed policy. Barclays’ Prada says the vacant Vice Chair position can be used to balance the policy bias of whoever is chosen as Chair.

With Yellen aside, Governor Jerome Powell would represent the closest thing to a continuity candidate for the big chair given he is an existing Fed board member and a dove, in other words somebody who favours lower interest rates. Much like Janet Yellen herself.

“He could be viewed as a little more dovish than current Fed Chair Janet Yellen,” says Hardman. “In late August, he stated that lower than expected inflation “gives us the ability to be a little bit patient and that’s not a bad thing”. He is also seen as modestly more supportive of bank deregulation.”

Current Fed governor Jerome Powell (Above). Source: Federal Reserve Gallery.

Former Fed official turned academic, Kevin Warsh, is also a frontrunner - some would even say a favourite for the nomination.

“Former Fed Governor Kevin Warsh has the most potential to prompt a shake-up of Fed policy expectations amongst the reported front-runners,” says Hardman.

Warsh has been a long time critic of the Federal Reserve’s post crisis monetary policy response, for much the same reason as the Republican Party has opposed it.

“We see Warsh as the most likely nominee, followed by current Governor Jay Powell. In the nearterm, Warsh would be more hawkish than current Chair Janet Yellen,” says TD Securities’ Hanson. “Warsh invariably represents the hawkish side, while Yellen and Powell typically would be seen as more dovish relative to the rest.”

Warsh was particularly opposed to QE and has advocated the idea of lowering the inflation target and taking asset prices, or more like so called bubbles, into account when setting interest rates.

“His potential appointment as the next Fed Chair would prompt the market to price in a faster pace of rate hikes and encourage expectations that the Fed could speed up the pace of balance sheet reduction,” says Hardman.

Hardman also notes Warsh is a strong supporter of President Trump’s efforts to boost growth through looser regulation and tax reforms.

Kevin Warsh. Source: Hoover Institution.

National Economic Council director, and former Goldman Sachs chief, Gary Cohn is another close contender for the Fed Chair although his chances have been seen as diminishing in recent weeks.

“He is viewed as likely to be a little more dovish than the Fed’s current policy thinking which could help to keep rates lower than otherwise,” says Hardman. “His strong support for President Trump’s plans to boost growth through looser regulation and comprehensive tax reform are more well-known.”

Also in the running is John B Taylor, a Bush era Treasury undersecretary and the man who coined the “Taylor Rule”, which is an interest rate setting model that claims a link between employment and inflation.

“The potential nomination of former Fed Governor Kevin Warsh or Stanford University President John Taylor could initially strengthen the US dollar sharply resulting in the dollar index rising by around 3-5%,” notes Hardman.

US Dollar Index at monthly intervals. Source: Netdania Markets.

Fed Chair: Important Considerations

Given the Federal Reserve’s sway over the fortunes of the US economy, Trump’s eventual choice of candidate is seen as likely to be one whose policy bias supports his own economic agenda.

“Trump would likely expect “his people” at the Fed to support 4% real GDP growth, a rise in manufacturing and blue collar employment, and declining bilateral trade deficits — via a weaker US dollar,” TD’s Hanson says. “This agenda calls for a dovish Fed, not a hawkish one.”

This would appear to rule out candidates like Taylor and Warsh, while favouring Powell, Yellen and Cohn. But it is not just the Fed chair that is up for grabs. The Vice Chair seat is also vacant and so too are a number of other FOMC chairs.

In addition, September’s inflation numbers and recent discussions among rate setters add a new dynamic to the debate.

Yellen and fellow FOMC members have recently begun to question whether there are more permanent factors weighing on inflation that Fed officials are currently unaware of.

This suggests theories around inflation, interest rates and economics in general could come under increasing scrutiny during the tenure of the next Chair.

As a result, President Trump may come under pressure to choose a candidate that not only supports his agenda, but who also has a lengthy CV and deep background in economics.

While occupying key financial roles, and having contributed greatly to many of the big economic debates in recent history, both Powell and Warsh are trained lawyers not economists.

This line of thought would appear to further narrow down the list, biasing selection away from Powell and back toward Yellen. That being said, the short list is by no means exclusive and an outsider candidate could yet emerge.