Of hawks and doves: Markets may have Fed candidates backward


According to numerous press reports, the president’s short list to replace Janet Yellen as the head of the Fed, should he not reappoint her, consists of current Fed Governor Jerome (Jay) Powell, National Economic Council Director Gary Cohn, Stanford University economics professor John Taylor and former Fed Governor Kevin Warsh.

While it is not totally inconceivable that the president picks someone else, the administration is said to be leaning toward Powell for its choice. Given the importance of the job and the markets’ skittishness over the looming appointment, here is what you need to know.

{mosads}If Janet Yellen is reappointed, the consensus view among market practitioners is that nothing on the monetary policy front will change. This makes sense. Chair Yellen has already laid out the Fed’s intention to gradually and mechanistically unwind the central bank’s balance sheet. It’s effectively on autopilot. Moreover, it is doubtful anything would change if Governor Powell moved up to the top spot either.


Powell, who has been a governor since May 2012, has consistently voted with the Yellen-led consensus. So by all indications, he was completely on board with quantitative easing (QE) Part 3 in September 2012 and the Fed’s announcement last month to begin balance sheet normalization.

Therefore, not much changes under a Yellen- or Powell-led Fed, but what about the other candidates, in particular Taylor and Warsh?

There is a view among some market folks that Taylor and Warsh would both be much more hawkish — i.e., proponents of tighter monetary policy — than either Yellen or Powell. It is probably true for Cohn, too, but his views on monetary policy are not known, as he spent the majority of his career working in investment banking on Wall Street.

Given little previous economic or monetary policy experience, Cohn would probably have to rely heavily on the Fed staff’s input. The upshot is that a Cohn-led Fed could look a lot like a Yellen- or Powell-run Fed. The markets’ rationale on Taylor and Warsh is pretty straightforward.

John Taylor prescribed a simple formula for the Fed to follow, which has become known as the Taylor Rule. Essentially, monetary policy makers need to change the funds rate whenever there are deviations in inflation and employment from their desired targets.

At present, the Taylor Rule is pointing to a much higher funds rate than its current 1.00-1.25 percent range. On the surface, the financial markets’ concerns are well placed.

For Kevin Warsh, his alleged hawkishness is less “quantifiable” than Taylor’s. However, given his harsh public pronouncements on the efficacy of unconventional policy actions that were made after he left the Fed in April 2011, in response to QE3, it is understandable why investors view a Warsh candidacy similarly? But are these views justified?

Janet Yellen and probably Powell, but perhaps to a slightly lesser extent, still view the inflation process as being driven by the labor market. A low and falling unemployment rate in their world will eventually sow the seeds of a pickup in inflation — it is just a matter of when the rate falls below its natural level that we have to be concerned.

If — and this is a big if — the administration and Congress are able to pass some version of tax reform, which ostensibly will not be revenue neutral, the economy should get a jolt. Depending on how much in taxes is cut, the impetus to real GDP growth could be quite large, at least for a time.

Under such a scenario, one could envision Yellen becoming more hawkish. How so? A tax-induced increase in growth would put upward pressure on wages, as firms bid for a limited supply of potential labor. This demand-pull/wage-push inflationary scenario would be met by higher rates. But this is not necessarily the case with either Taylor or Warsh.

In fact, Taylor or Warsh would probably be more patient in raising interest rates than Yellen if only because their political tendencies lean more supply-side. In other words, if lower corporate tax rates and accelerated expensing of business investment leads to a significant amount of capital formation, underlying productivity growth could meaningfully accelerate.

Against such a backdrop, inflationary pressures could remain dormant, despite historically low unemployment. Consequently, Taylor or Warsh might actually be quite dovish, at least for a time. So where does that leave us?

The financial market should not be overly worried about who runs the Fed. Chair Yellen and the four other candidates are uniquely qualified. Furthermore, investors should not jump to conclusions as to who is dovish or hawkish. In the current environment, where the administration is trying to pass tax reform, traditional labeling may be incorrect.

Joseph LaVorgna is Natixis’ chief economist for the Americas. Natixis is the international corporate and investment banking, asset management, insurance and financial services arm of Groupe BPCE, the second-largest banking group in France. LaVorgna is a frequent contributor on CNBC.

Tags Central bank economy Inflation Interest rate Janet Yellen John Taylor Kevin Warsh Monetary policy Quantitative easing Taylor rule

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