Meet the new Fed boss, not quite the same as the old boss

Meet the new Fed boss, not quite the same as the old boss
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Monetary policy ended 2017 as expected, with the Federal Reserve ushering in a third hike for the year and taking the federal funds rate to a range of 1.25-1.50 percent. Furthermore, the Fed forecasted three additional rate hikes in 2018.

Looking forward, however, amid continued job growth but still-sluggish inflation, the pathway for future policy adjustments appears increasingly uncertain, particularly amid a change in leadership as Chairwoman Janet Yellen hands over the reins to Governor Jerome Powell.

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The Senate approved President TrumpDonald John TrumpWhere do we go from here? Conservation can show the way Gov. Ron DeSantis more popular in Florida than Trump Sotomayor accuses Supreme Court of bias in favor of Trump administration MORE’s nominee, Jerome Powell, to become the next chairman of the Federal Reserve on Tuesday, replacing Yellen come February. Widely expected to be confirmed with relative ease, the vote was finalized at 84 to 13 in favor of Powell, gaining support from both sides of the aisle.

 

Powell is generally seen as a centrist and a consensus-builder among colleagues. He has furthermore been hailed as a thoughtful policymaker and seen as a relatively safe bet for central bank leadership. Certainly, Powell was the safest bet relative to the short list of names being considered, including famed Stanford economist John Taylor and National Economic Council Director Gary Cohn, who were seen as potential disruptors or, at the very least, unknowns.

Powell has championed the policies of the Federal Reserve enacted under former Chairman Ben Bernanke and more recently, the continued low-rate policy under Yellen. Going forward, however, there is no guarantee that Powell will continue to walk in Yellen’s footsteps, particularly when it comes to regulation and expectations for rates.

In the past, Yellen has spoken highly of the regulation put in place in the aftermath of the Great Recession, arguing such policy action helped stabilize the financial sector and furthermore, will act as a welcomed layer of protection against similar fallout in the future.

Powell, on the other hand, has been quite vocal against the ample regulation put in place over the past decade. Stopping short of echoing the Republican’s cry of overly burdensome regulation stunting financial institutions and, by extension, overall growth prospects, Powell has suggested a need to reduce needless regulation.

There is one other key difference between Yellen and Powell: anticipation. Yellen is a strong believer in the Philips Curve and the current models the Fed uses to predict future levels of growth and inflation as justification for anticipatory monetary policy action.

As such, despite incorrectly predicting higher inflation for the past near-decade, Yellen has been more than willing to raise rates near-term in anticipation of stronger price pressures in the future. Powell has been reluctant to support such blind optimism.

While voting along with policy decisions over the past years, Powell has noted in his public comments the lack of current evidence for a tight labor market and furthermore, a near-term reversal in inflation back to the Federal Open Market Committee’s (FOMC) longer-run target of 2 percent.

As a result, a Powell-led Fed may be more willing to err on the side of patience, waiting for further evidence of rising inflation first before taking additional steps to remove policy accommodation. Thus, the pathway to higher rates may be slower and lower for longer under Powell than it would have been had Yellen been invited to remain at the helm for another term.

Aside from a change in leadership, the Fed will face additional uphill battles to meet expectations of three hikes in 2018, including the current shape of the yield curve. Although recently steepening off more pronounced lows, the spread between the 2-year Treasury and 10-year Treasury bond yields remains historically low.

In other words, the Fed has very little wiggle room to continue to tighten without eventually facing the risk of inverting the curve, a phenomenon which has proceeded every economic recession in post-WWII history.

Overall, market participants would be well advised to keep expectations in check. After all, the Fed has historically over-promised in terms of rate hikes for the following year. In 2014, looking out to 2015, the Fed anticipated numerous rate hikes and delivered only one.

A similar story played out in 2015, as the FOMC offered a forecast for 2016 that anticipated several hikes but delivered only one. While estimates for four or more hikes were plentiful, the Fed did deliver closer to expectations in 2017 with three rate hikes.

This time around, with three rate hikes forecasted for 2018, it’s likely the FOMC has once again oversold its hand.

The Fed will continue along a path of higher rates at a pace justified by the underlying momentum in the economy as the committee remains, first and foremost, data-dependent.

Therefore, unlike the anticipatory liftoff in December 2015 or the recent run-up in the market fueled by expectant pro-growth policy and tax reform, the Fed will increasingly judge the appropriateness of rate hikes on the economic soundness of the American economy.

The Fed is likely to disappoint the market and return to a one-rate-hike-a-year policy agenda again in 2018, driving down rates on the longer-end of the curve.

Lindsey Piegza, Ph.D., is the chief economist for Stifel Fixed Income. Her research has been published in the Harvard Business Review and in textbooks for Northwestern University's Kellogg Graduate School of Management. She's a regular guest on CNBC, Bloomberg, Fox News and CNN.