The Fed Open Market Committee (FOMC) which sets monetary policy met on July 25-26. As expected, the Committee made no monetary policy changes and left the Fed Funds rate unchanged at 1.0-1.25%. The policy statement which followed the late July meeting reflected the fact that inflation continues to run well below the Fed’s target rate of 2%.
This leaves the Fed in a very uncomfortable position. On the one hand, the Committee feels the need to raise the Fed Funds rate to more normal levels; but on the other hand, it does not want to choke-off the rather feeble economic recovery. It’s really that simple.
The debate is highly charged on both sides. Advocates for raising interest rates argue that the Fed needs to hike short-term rates ASAP to give itself room to lower rates again when we hit the next recession. Those who prefer keeping rates low argue that the economy is not yet strong enough to withstand higher interest rates, and doing so could spark a new recession.
Both arguments have merit. As such, the Fed has no good policy options right now. Despite that, the prevailing wisdom is that the Fed will raise rates at least one more time this year, either at the September 19-20 meeting or the December 12-13 gathering.
In the Fed’s policy statement released on July 26, the Committee added the words “relatively soon” which made many Fed-watchers conclude that another rate hike could well happen at the September FOMC meeting. Either that or the Fed might vote to begin reducing its $4.5 trillion balance sheet at the September meeting. But not both at the same time, most likely.
Most Fed-watchers are now referring to the upcoming reductions in the Fed’s balance sheet as “quantitative tightening” or QT. The Fed has hinted that its balance sheet reduction will begin in increments of approximately $6 billion per month and slowly rise to $30 billion per month over the year following the first reduction.
Fed Balance Sheet Reduction Usually Results in Recession
The Federal Reserve’s looming attempt to shrink its mammoth portfolio of bonds and mortgages comes with an ugly track record. Virtually every time the central bank has shrunk its balance sheet in the past, recessions have followed.
Over the past several months, the Fed has prepared the markets for the upcoming effort to reduce the $4.5 trillion it currently holds of mostly Treasuries and mortgage-backed securities. The balance sheet ballooned to this unprecedented level as the Fed sought to stimulate the economy out of its financial crisis morass by purchasing these securities.
Fed Total Assets
The Fed has embarked on six such balance sheet reduction efforts in the past — in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000.
Of those six instances, five ended in recession, according to research from MKM Partners. This balance sheet trend mirrors what has happened much of the time when the Fed has tried to raise rates over a prolonged period of time, with 10 of the last 13 tightening cycles ending in recession.
Even worse, the Fed’s balance sheet has never been remotely as large as it is today, so there is no precedent for the large decreases that are planned to begin later this year and into next year or longer. Starting as early as late September, the Fed is expected to initially begin letting $6 billion in securities mature each month and not be repurchased. As noted above, that amount will be gradually increased to $30 billion or more each month.
The Fed has hinted that it will reduce its balance sheet from approximately $4.5 trillion currently to $2.5-$2.0 trillion over the next several years. Chair Janet Yellen likes to say the process will be akin to “watching paint dry” and won’t be disruptive to markets.
Yet skeptics (counting me) question whether it will be so painless. The Fed is going to attempt reducing its balance sheet by record amounts, while at the same time trying to “normalize” (increase) short-term interest rates. This potentially dangerous combination could be the catalyst for a serious downward correction or bear market in stocks, which could trigger the next recession.
President Trump Can Dramatically Reshape the Fed
Making matters even more complicated is the fact that the makeup of the FOMC is likely to change significantly in the next few years. Fed Chair Janet Yellen’s term in office expires in February, and most Fed-watchers don’t believe President Trump will reappoint her.
Trump has done little to address Yellen’s future. During the presidential campaign in 2016, he spoke harshly of her, accusing Yellen of orchestrating monetary policy to benefit the economy under the Obama administration. But since becoming president, he has reportedly said he thinks Yellen is doing a good job, and that he prefers continued low interest rates. Who knows?
If President Trump decides to replace Ms. Yellen in February, a possible replacement is thought to be Gary Cohn who is currently the president’s chief economic advisor. Formerly he was the CEO of Goldman Sachs from 2006 to 2017. He is an investment banker through and through.
In addition to replacing Ms. Yellen, President Trump has the opportunity to reshape the Fed as no president since at least Ronald Reagan. Here’s why. The FOMC is made up of 12 members: seven are the members of the Federal Reserve Board of Governors; four are Federal Reserve Bank presidents; plus the president of the New York Fed.
In addition to Yellen’s possible departure in February, Fed Vice-Chairman Stanley Fischer’s term is also up in the first half of next year. Most Fed-watchers believe Mr. Fischer will leave the Fed when Ms. Yellen does.
In addition, there are two current vacant spots on the FOMC that President Obama was unable to fill. Plus, another spot will open up in April when Fed Governor Daniel Tarullo retires. And New York Fed president, William Dudley, has announced that he will retire in January of 2019.
That makes a total of six FOMC members President Trump will have the opportunity to replace between now and January 2019. As such, the Fed policy committee could look substantially different in the not-too-distant future.
What Fed Policy Changes Should We Expect Just Ahead?
So, what will Fed policy look like given the wholesale shakeup of the FOMC by President Trump? As with so many other issues, Trump’s own views are very difficult to determine. As noted above, during the presidential campaign, Trump called himself a “low-rate person,” suggesting he approved of the Fed’s zero interest rate policy. Yet on other campaign occasions, he attacked the Fed’s low-rate policy for creating a “false economy.” So which is it?
Our next clues will likely be Mr. Trump’s first two nominations to fill the two currently empty FOMC seats. Press reports suggest that the president is considering nominating Randal Quarles and Marvin Goodfriend for these two positions, and the White House has not disputed such claims.
Randal Quarles is a seasoned financial guy, formerly a partner at the Carlyle Group, one of the world’s largest private equity firms. He was also the US Under-Secretary of the Treasury for President George W. Bush. Marvin Goodfriend is a former Fed economist and is currently a professor at Carnegie Mellon University.
In addition to their financial backgrounds, both Quarles and Goodfriend are considered to be conservatives when it comes to monetary policy. Assuming Trump actually nominates them and they are confirmed, their addition to the FOMC could be uncomfortable for Janet Yellen who is quite liberal when it comes to monetary policy. But again, Yellen may be gone in February of next year.
I’ll keep you abreast of the upcoming changes at the Fed months ahead. I’ll leave it there for today.
Gary D. Halbert is the president and chairman of Halbert Wealth Management, Inc. His Forecasts & Trends Weekly E-Letter may be obtained free of charge by subscribing at www.halbertwealth.com.