On the Fed choice, if it ain't Yellen, I'll be sellin'

  • President Trump is expected to announce his choice for the next Fed leader in the coming weeks.
  • A couple of favorite candidates adhere to a rules-based approach to monetary policy.
  • As we learned in prior economic periods, models can often be defective.
Former Federal Reserve Board Chairwoman Janet Yellen speaks during a news conference following a meeting of the Federal Open Market Committee September 20, 2017 in Washington, DC.
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Former Federal Reserve Board Chairwoman Janet Yellen speaks during a news conference following a meeting of the Federal Open Market Committee September 20, 2017 in Washington, DC.

In what may be the single most important decision of his still-young presidency, Donald Trump is nearing the moment in which he names the next chair of the Federal Reserve.

I am operating on one principle here: "If it ain't Yellen, I'll be sellin'!"

Published reports say President Trump is meeting with Stanford University Professor John Taylor today at the White House. Another report suggests that former Federal Reserve Governor Kevin Warsh may be the most likely pick to head the Fed. They are among the 10 candidates to take the job when current Fed Chair Janet Yellen's term expires early next year, including Yellen herself.

To be clear, I know Warsh and respect him. However, like John Taylor, he has long been in favor of a so-called "rules-based" policy at the Fed.

Let me explain. Taylor is the originator of the very rule followed by Warsh and the Republican-controlled Congress. The "Taylor Rule" is an interest rate forecasting model that raises or lowers rates based on the "output gap" in the economy. That refers to the difference between the economy's growth potential and its actual pace of growth.

The president has decried sluggish growth since he began running for office in late 2015, but the "Taylor Rule" would have had the Fed raising interest rates several times over the last few years.

Taylor and Warsh have advocated for a faster pace of rate increases, or "rate normalization" throughout the last several years. They have suggested that the Fed's recently policies could lead to any number of outcomes … asset bubbles, higher inflation, or an inability to return the Fed's balance sheet to a more normal size without some sort of market disruption.

So far the Taylor Rule, or a modified version of it, has been proven wrong.

One can only wonder what kind of beating the economy would have taken if this type of rules-based policy had been implemented, either before or after the crisis.

The Fed would have likely never initiated the aggressive policies needed in 2008 and 2009 to ward off another Great Depression.

Nor would it have allowed the Fed to keep rates low enough to ensure what is now the third longest economic expansion of modern times.

It is quite obvious to me that monetary policy is as much art as it is science. Relying solely on a black box, autopilot policy can be quite dangerous.

As we learned in prior economic periods, models can often be defective. In the 1970s and '80s, "econometric modeling" was in vogue. It failed spectacularly in capturing the wrenching periods of rising inflation, interest rates and unemployment that hammered the economy back then.

The Phillips Curve, on which the Fed still partially relies, has proven equally weak in capturing the economic reality of the 1990s and today, both periods of falling unemployment and a distinct lack of inflationary pressures. Unemployment and inflation are, according to the Phillips Curve, supposed to move in inverse lock step. They have not.

Both Yellen and her predecessor at the Fed, Ben Bernanke, have proven that the Fed needs to be nimble, open-minded and extremely deliberative in assessing current conditions and weighing the risks and rewards of rate craft.

They both have argued that no strict, simple model can capture the myriad variables, both at home and abroad, that can shock the economy, for good or for ill.

They have been proven correct in that regard.

Yellen has also been an advocate for maintaining at least some of the post-crisis regulations that have bolstered bank capital and liquidity while also keeping banks out of business lines that helped precipitate the last, devastating crisis.

One gets the sense that Warsh and Taylor would follow the President's lead and undo some of the safeguards that have kept the animal spirits from running too wild on Wall Street.

Former Bush economic advisor Glenn Hubbard or Fed official, Jerome Powell, would be suitable replacements for Ms. Yellen. Hubbard is seen as a long shot, however, and Powell only recently started rising in the prediction markets as a possible choice.

Gary Cohn, the President's top economic advisor, as I have argued before, also ain't the man for the job, given his rather obvious lack of experience in this kind of banking. He is a former trader who was president of Goldman Sachs before joining the Trump administration.

I hope, as I did with President Obama and Chairman Bernanke, that this president prefers continuity to chaos.

And in the main, without a steady, experienced and battle-tested veteran at the head of the Fed, chaos in interest rate policy might just be the biggest risk the markets will face in the months and years ahead.