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Interest-Rates / US Bonds Jul 03, 2017 - 03:47 PM GMT

By: John_Mauldin

Interest-Rates

Speaking at a Business Roundtable event, New York Fed President William Dudley reportedly expressed great confidence in both the economy and the Fed’s policy moves.

Dudley is not even slightly concerned about the Fed’s overshooting with its rate hikes. In fact, he is supremely confident that inflation will overshoot if the Fed doesn’t tighten policy.


Even more disturbing, a MarketWatch story says that Dudley remarked that he “is not paying much attention to signals of concern from the bond market.”

Read that again.

The NY Fed’s president is a permanent FOMC member because he is closest to the bond market and is responsible for executing the Fed’s trades. Yet by his own admission, he ignores the market’s concerns.

That’s kind of an important signal. Dudley’s job is to listen to it. If he’s not listening, why not?

I have a theory.

Great Fed Rotation

All this is happening as the Fed is on the cusp of drastic change.

The Federal Reserve System has a seven-member Board of Governors. Three of those seven seats are now vacant. President Trump has not nominated anyone yet. Although two names have been floated in the press (including NIRP lover Goodfriend).

Even if Trump were to nominate them tomorrow, they would still have to go through Senate confirmation, and the Senators have a lot on their plates.

Meanwhile, Janet Yellen’s term in the chair expires on February 8, 2018. And Vice-Chair Stanley Fischer’s term ends in June 2018. Their board terms are separate, so in theory, both could remain governors after their leadership terms expire.

But most observers expect them to retire.

So, if things go as expected, Trump will have two more seats to fill. This means we are one year away from a Board of Governors with at least five of the seven being Trump appointees.

And it seems highly likely that Lael Brainard will not stick around much longer after Yellen leaves, and then the only question remaining is whether Jerome Powell steps down.

President Trump does not appoint the regional Fed bank presidents. They answer to their own boards, which comprise of bankers from their regions. So the FOMC has both political appointees and commercial bank representatives. It was set up that way on purpose.

But it’s also no accident that the political appointees constitute a majority—or will when more Trump appointees take their seats.

Hawkishness Out of Political Necessity

The FOMC works by consensus.

Most of its decisions are unanimous or almost unanimous. Fed chairs strive to get everyone on the same page. It’s also important because banks and private businesses want to see stability.

Enter Donald Trump, for whom stability is a lesser priority.

The FOMC members must see what is coming. Their beloved unity is in danger, and I doubt they are pleased. I believe a faction on the FOMC wants to cement its own preferred policies in place and make it difficult or impossible for a new majority to change course in 2018 or afterward.

Yellen, Fischer, and Dudley all seem to be of that mind, and they are now taking a hawkish approach to monetary policy. That’s why they don’t want to do the otherwise sensible thing, which is to wait for more evidence that inflation is a problem before tightening further, especially so late in the recovery cycle.

Can Trump fire Fed governors, like he did the FBI director? Maybe. The Federal Reserve Act says governors can be “removed for cause by the president.” He could certainly find cause if he wished to do so. But firing Fed governors would send a horrible signal to markets.

Far better to give them incentives to resign, which could be done quietly. And frankly, I think those around him would let him know that firing would be a really bad idea. Just not done. Independence of the Fed and all that…

In any case, right now we have a Fed that is arguably letting its own parochial political concerns seep into its policy decisions. By raising rates when inflation is nowhere near problematic, they risk tipping the economy into recession.

We’re overdue for a recession anyway, and I get that they want to have room to cut rates if necessary. But that will be cold comfort if their own actions trigger the recession. But it even goes further than that…

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