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Jack M. Mintz: Who is Fed chair does matter

If Powell is wrong on inflation, it will eventually require contractionary monetary policy and much higher interest rates

Author of the article:

Jack M. Mintz

Jerome Powell, chairman of the U.S. Federal Reserve, speaks in the Eisenhower Executive Office Building in Washington, D.C., on Nov. 22, 2021.
Jerome Powell, chairman of the U.S. Federal Reserve, speaks in the Eisenhower Executive Office Building in Washington, D.C., on Nov. 22, 2021. Photo by Samuel Corum/Bloomberg files

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After months of speculation, President Joe Biden has nominated the current chairman of the Federal Reserve Board, Jerome Powell, to serve another term. And he proposed Powell’s main rival, Lael Brainard, for the position of vice-chair, which means she will play an influential role in monetary policy in coming years. Both appointments are likely be confirmed by the U.S. Senate.

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Powell, a Republican, was appointed to the board in 2014 by Barack Obama and to the chairmanship in 2018 by Donald Trump, replacing Janet Yellen, now Secretary of the Treasury. Powell’s monetary policy has focused on economic growth, which has been below potential. He has argued that inflation, now running at over six per cent, should be temporary as supply bottlenecks disappear next year. Ms. Brainard, a Democrat also appointed by President Obama in 2014, holds similar views.

When it comes to monetary policy, this seems to have been a choice between Tweedledum and Tweedledee. Where Powell and Brainard do differ is on financial regulation. Brainard would like bank lending rules to be more stringent and have the Fed focus more on social policy goals like inequality and climate change. (In Canada, in contrast, responsibility for financial regulation resides primarily with the Department of Finance.)

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Biden was caught between placating progressives in his party, who favoured Brainard, and centrists and the business community, who wanted Powell and continuity. That Biden chose Powell speaks to the latter’s success in gathering sufficient Democratic support, including from Secretary Yellen, a key economic advisor to the president.

The elaborate political maneuvering around the choice of Fed chair begs the question as to whether it makes any difference to monetary policy whether a Democrat or a Republican president chooses the chair. For several decades, Western economies have established a practice whereby central banks are independent in setting interest rates, without direct political interference. Overt political intervention in which politicians pushed for low interest rates in an overheated economy could easily lead to a currency crisis. An example is Turkey, where President Recep Erdogan has fired central bank governors unwilling to cut interest rates. The Turkish lira is down 30 per cent this past year and annual inflation is at 20 per cent.

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Although most Western leaders wouldn’t think of firing the head of their central bank their choice for that job can still influence monetary policy. In a recent research paper, economists Emile van Ommeren and Giulia Piccillo looked at the behaviour of central banks under different leaders, depending on whether they were appointed by left- or right-leaning governments. They included six countries (the U.S., U.K., Czech Republic, Hungary, Japan and Sweden) that make decisions via a policy council and another six (Canada, Denmark, Israel, Korea, Mexico and Norway) where monetary policy is primarily the governor’s responsibility. With monetary policy councils, the governor does not have full control over decisions, but winning coalitions often typically include the chair, who has the most influence over the agenda and research.

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Van Ommeren and Piccillo found that more right-wing parties tended to pick governors who were more inflation-averse in setting interest rates, whether or not the governor or a council made the decision. On average, right-wing appointees increased interest rates by 0.2 to 0.3 percentage points more than left-wing appointees did when inflation was one point above target.

The authors also found that Janet Yellen, appointed by a Democrat, was much softer on inflation compared to Ben Bernanke, who had been appointed by Republican George W. Bush. When the U.S. economy perked up in 2013, Bernanke indicated that the Federal Reserve would pare back its purchases of treasury and corporate securities, which resulted in a “taper tantrum” that sent bond yields sharply up. Yellen had none of this: she avoided any hint of interest rate hikes.

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Which gets us to today’s challenging economic and political environment. Central banks are facing much greater uncertainty over inflation which until this year has run a little below two per cent since the 2008 financial crisis. As the result of this uncertainty, Federal Reserve inflation forecasts have been dreadfully wrong. As late as March 2021, the Fed was forecasting 2.4 per cent inflation in 2021, embarrassingly below the current year-over-year CPI increase of 6.2 per cent through October.

Many Democrats want a soft approach to monetary policy: tighter money and an economic contraction would only spell trouble in next year’s mid-term elections. Meanwhile, the Republicans are painting inflation as another Biden policy failure, as the effects of supply shortages are compounded by overly expansionary infrastructure and social spending. With expansionary fiscal policy and Powell’s continuing soft monetary policy, count on above-target inflation in 2022, for sure.

If Powell is right on inflation, then the economy can continue to grow at its potential without higher interest rates. But if he is wrong, inflation will eventually require contractionary monetary policy and much higher interest rates. If not, a Turkish-style policy of keeping interest rates low and inflation high will be a gift to the Republicans.

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