Fed Put On Watch By Congressional Vice Chairman Of Financial Services

The chances of a rate hike in March has fallen from 17.7% to 13.3% and the chances of zero rate hikes this year has risen to 6.9%. Besides Trump’s rhetoric, the lack of hawkishness by the Fed is also hurting the dollar. The market participants always convince themselves that this year will finally be the one where the Fed follows through on this initial projections for a few rate hikes. Steve Liesman mentioned that the Fed may start discussing shrinking the balance sheet in mind-2018. These types of projections are always pushed out far enough that they can be delayed without anyone noticing.

Keep in mind, all of my projections above are based off of the current Fed, but can immediately be changed after Trump appoints two new governors and possibly changes the Fed chairperson next year. This brings me to the biggest news on the monetary policy front since Trump was elected. Today it was reported that Patrick McHenry, Vice Chairman of the Financial Services Committee, wrote Janet Yellen a strongly worded letter. I have a screengrab of the letter below.

While Trump didn’t write this letter, it is in coordination with the White House’s thoughts on the Federal Reserve. There wasn’t a letter like this when George Bush was president because he wasn’t critical of the Fed like Trump is. The Federal Reserve is supposed to be apolitical. However, it hasn’t been apolitical for as long as I’ve been following it. This aggressive stance is similar to previous executive branches’ policies regarding the Fed. The difference this time is it is public and blunt.

One signal that the Trump administration would take a harsh tone with bureaucrats was his firing of Sally Yates, the attorney general, when she didn’t enforce the temporary travel ban. Therefore, it’s not a surprise when an Obama pick doesn’t follow his ethos, he will have a strong negative reaction. I don’t expect any major reaction such as Trump firing Yellen because she isn’t directly going against any of his polices. He hasn’t done any executive actions on monetary policy, so it’s not as if Yellen is defying his plans.

My understanding of Trump’s monetary policy is that he is in favor of unwinding the balance sheet and returning to a ‘rules based’ interest rate system where rates would change based on something like the Taylor rule. The Taylor Rule is a forecasting model which provides guidelines where interest rates should be. The theory on why it would be successful is that it is more predictable because once data is released, investors know where rates will go. While the Fed claims it is data dependent, investors still have to guess how the Fed will interpret the data.

Also, because the Fed tries to avoid spooking the market, it doesn’t raise rates when the market isn’t pricing in at least a 70% chance of a rate hike. This makes the Fed dependent on the market. If rate changes are more autonomous, it takes the power of the direction of interest rates back from the market. The Taylor Rule also prevents the Fed from going ‘rogue’ and making extraordinary policies. The reason it is getting more coverage now is because some think the Fed is acting in a rogue manner. The Federal Funds rate is way below where the Taylor Rule says it should be. As you can see, the Taylor Rule says interest rates should be much higher than they currently are at. It supports Trumps election claim that the Fed was propping up an equity bubble.

The first paragraph of the letter calls into question the Fed’s participance in international monetary policy forums. While I agree the Taylor Rule explains the Fed’s near zero interest policy is unwarranted, participating in international forums isn’t a new thing. Whether the Fed participates in forums, doesn’t influence international monetary policy relationships. This is because currencies will react to each monetary policy put in place which forces individual country’s central banks then to react to the changes.

The second paragraph gets into more of the substance of the letter. Just like how Trump is advocating the United States leave the Paris Agreement, which deals with environmental regulations, it looks like international financial regulations will be eliminated. This will be great for the banks as any regulatory cut is a cost cut. The question is what the international regulations will be replaced with. I think there’s a good chance many won’t be replaced.

The third paragraph criticizes the way these negotiations occur. In the Federal Reserve’s defense, the American public doesn’t understand monetary policy. If it becomes more transparent, there wouldn’t be much of a benefit. However, Patrick McHenry may be criticizing the fact that unelected FOMC members are deciding rules with international policy makers. This is the antithesis of the populism associated with Trump’s election.

The final paragraph has harsh tones for the Fed. It tells it to cease any negotiations until Trump has the chance to appoint new officials to the job. This means President Trump’s appointments for the two open governor positions will likely come in the next few weeks. I’ve been thinking about who he will pick based on the concept that if he picked governors soon, they would be hawks. If he waited to make the picks, they’d likely be doves. My reasoning behind this is tax cuts and stimulus spending will cause deficits which the Fed must make up for with QE. When Trump realizes this, he will be pressured to pick doves. However, his current cabinet picks have all been in a certain pro-business mold which would be more associated with a hawk.

Conclusion

Trump’s picks for Fed governors will impact the market more than anything he’s done or said so far. The media doesn’t cover this as much because most everyday Americans don’t follow monetary policy. I am now expecting him to pick two hawks. This means interest rates may head higher and the government bonds will be sold. It’s impossible to make projections on interest rates until the selections are made and Trump comments on who he’ll pick as chairperson. The market is not pricing in this change. The market is forecasting two rate hikes for the year, but there may be many more after Trump makes his selections. I expect volatility when the market starts pricing in more hikes. More rate hikes could cause the dollar to strengthen.