Federal Reserve

The Trump Fed: New faces, but less experience and so bigger chances for a market disruption

Key Points
  • With the announced departure of New York Fed President William Dudley, the Fed will be without all three of its top-ranking officials of the past several years.
  • Along with Dudley's exit next year, current Chair Janet Yellen also may choose to leave after she is replaced as chair, while Vice Chairman Stanley Fischer left in October.
  • Economist David Rosenberg believes investors should be "long volatility" amid disruptions caused by a less experienced and more hawkish Fed.
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The Federal Reserve will not only lose its three top-ranking officials in the months ahead but also the more than three decades of experience they brought to policymaking.

In their place will be central bankers who could take quite a different approach to policy, a change the financial markets may not fully appreciate yet.

New York Fed President William Dudley became the latest Fed official to say he'll be leaving soon, announcing Monday that he'll be stepping down in mid-year. That comes just days after President Donald Trump said he will nominate Fed Governor Jerome Powell to take over the chairman's seat from Janet Yellen in February, and less than a month after the departure of Vice Chairman Stanley Fischer.

That in effect takes out the ruling troika of monetary policy since early 2014, a group that holds some 35 years of monetary policy experience.

The initial take on Powell is that he will largely carry on Yellen's work, with a dovish approach to interest rates and a desire to unwind the Fed's $4.5 trillion balance sheet in a gradual manner.

However, Trump still has a lot of work to do in terms of Fed vacancies.

'Fierce lobby' for one candidate

There are three openings yet to be filled on the Fed's seven-member board of governors — four if Yellen decides to step down after she is replaced as chair. There's no guarantee that Trump will pick a centrist in the Powell image to fill those other seats

In fact, the president is facing a "very fierce" lobby from congressional Republicans to nominate Stanford economist John Taylor for a vacancy, said Larry McDonald, a veteran Wall Street bond pro and founder of "The Bear Traps Report" investor newsletter. Taylor would be expected to follow his eponymously named rule that prescribes where the Fed's benchmark funds rate should be based on economic data.

Many Republican Fed critics favor a rules-based approach to policy, and in Taylor's case that could result in considerably higher rates.

"They look at this like the Supreme Court. The conservatives want a Gorsuch in there," McDonald said, referring to Supreme Court Justice Neil Gorsuch, a Trump appointment. "They don't want another labor market economist quasi-socialist who wants to use the bank as a social engineering platform. They want a rules-based mechanism."

McDonald, who said he met with three key senators on Capitol Hill last week, said the GOP would look favorably on Taylor or former Governor Kevin Warsh, who once was considered a front-runner for the Yellen seat and also is expected to take a more hawkish view. Neither Taylor nor Walsh responded to requests for comment.

"The market is probably a little complacent towards a rules-based shift," McDonald said.

Warsh carries the experience of being on the Fed during the financial crisis, though Taylor would be a newcomer. Powell himself only came on board in 2014, which was after the Fed had halted its monthly bond buying program that bloated the balance sheet, and just before it was about to come off the zero interest rate policy that had prevailed since late-2008 during the worst of the financial crisis.

President Donald Trump looks on as his nominee for the chairman of the Federal Reserve Jerome Powell takes to the podium during a press event in the Rose Garden at the White House, November 2, 2017 in Washington, DC.
Drew Angerer | Getty Images

What Trump wants

That lack of ingrained economic orthodoxy could be a plus with Trump, though. His appointments have been consistently in favor of professionals over academics, and much of Wall Street expects the president to follow suit when it comes to the central bank.

"We're seeing a wondrous evolution of non-economists. It's good to have somebody like Powell. He actually understands the markets," said Christopher Whalen, head of Whalen Global Advisors. "You can't have the tyranny of the economists, people who think negative interest rates are viable policy."

Whalen himself worked at the Fed for 4½ years back in the mid-1980s before moving on to investment banking and other endeavors, and said he will seek the New York Fed president's position himself.

"I'd love to do it, I'd be honored," he said.

While Trump has power to nominate the other vacancies, he will not fill the New York Fed slot. That process happens internally and could come from someone closer to the branch's inner workings.

Some of the initial front-runners include Brian Sack, who formerly led the office's pivotal trading desk, as well as Simon Potter, who currently holds that position, and Potter's deputy, Lorrie Logan, according to a note from Michael Gapen, chief U.S. economist at Barclays. Sack now works at D.E. Shaw and could not be reached for comment, while a spokeswoman for the New York Fed said neither Potter nor Logan would be made available.

In a news release that confirmed Dudley's intentions, the New York Fed said the process to fill his position likely would take into mid-2018, a likely cause for why Dudley resigned early with his term not expiring until 2019.

The case for volatility

So while the New York appointment could be more along the status quo line, the other vacancies could make for a less conventional environment. Though market reaction has been muted regarding the Fed machinations, there are some rumblings.

The Trump Fed will be one with "much less experience, a Fed being led by someone who was not around when the balance sheet was built up and as such has little knowledge about how to shrink it without disruption," David Rosenberg, chief economist and strategist at Gluskin Sheff, said in his daily note Monday. "This is a great prescription for heightened market volatility (not to mention a more hawkish FOMC membership in 2018)."

Echoing McDonald's comments, Rosenberg said investors should be "long volatility," or prepared for market disruptions that could come under the new Fed makeup.

The potential for market disruption will be important for Trump, who has frequently boasted of the stock market's performance since his election and has stressed the need for a weak dollar and low interest rates.

Powell faces the challenge of balancing all of that at time when the Yellen Fed pushed for normalization of policy off the crisis-level measures that helped stabilize and grow markets and the economy.

"Unlike his predecessors, who have been prominent academic economists, Powell will be less able, at least initially, to drive consensus through a recognized and respected expertise in monetary policy and economics," Peter Hooper, chief economist at Deutsche Bank, said in a note. "A key question is how Powell will handle the pressures that will come if and when inflation finally does heat up and the Fed has to tighten policy more aggressively, with negative implications for the markets and more."

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