Expect More Rules and Less Discretion from the ‘New’ Fed

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The recent announcement of Vice-Chair Stanley Fischer’s impending retirement from the US Federal Reserve’s Board of Governors opens up another opportunity for President Donald Trump to recast the leadership of the central bank.

A key reason to make changes at the Fed would be to limit its discretionary powers, which now encompass monetary, fiscal, regulatory and supervisory policies. These powers grew dramatically over the past three decades, making the Fed the financial system’s most powerful discretionary authority.

The Trump administration wants to reduce the Fed’s regulatory authority
President Trump has the opportunity to appoint at least five new governors before his term is even half-completed. Mr Trump will likely look for candidates whose priorities align with his own:

  • Rolling back the Fed’s regulatory authority and enforcement.
  • Restoring the central bank’s independence within government.
  • Separating monetary policy – narrowly defined – from fiscal policy.
  • Advocating for a rule-based approach to the formulation and implementation of monetary policy, with a renewed emphasis on money-supply growth as well as interest-rate targeting.
  • Demonstrating sensitivity to the needs and challenges of regional and community banks.
  • Taking a pro-business approach consistent with the views of his administration.

The president may also prefer candidates who possess strong leadership skills and have senior-level experience at the Fed. All told, it is unlikely – though not impossible – that Janet Yellen will be reappointed as Fed Chair. Either way, there is already an appointee awaiting US Senate confirmation who has long favoured less regulation: Randal Quarles, who is in line to be Vice-Chair for Regulation.

Among advisors with the ear of the Trump administration, the reduction of the Fed’s regulatory authority is a top priority. These advisors believe that the Fed suffers from regulatory over-reach that has extended the operations of the central bank well beyond its legislated missions – putting the US economy and financial system at greater risk. What’s more, analyses by administration staff and its trusted advisors conclude that the Fed may now be more politicized and less independent than it has been at any time in its history, with the exception of 1936-1951, when it lacked effective monetary-policy authority.

The problem with informal guidance and politicization
What makes the Fed such a political force is its ability not only to institute formal rules, but also to issue informal “guidance”. The problem with issuing guidance without firm and explicit rules is that it maximizes the Fed’s discretion while minimizing regulatory accountability.

Regulation via guidance also presents opportunities for misbehaviour. Without clear rules limiting political pressures, it is possible for regulators to cede ground to special-interest groups and their representatives.

A strong example of this kind of politicization can be seen in the Fed’s earlier involvement in “Operation Chokepoint”. Led by President Barack Obama’s Attorney General, Eric Holder, this effort enlisted the help of Fed regulators to extend their regulatory powers (ie, by imposing higher capital requirements or withholding permission for transactions) to pressure banks into eschewing dealings with enterprises that the Obama administration found undesirable.

In a similar way, the discretionary powers given to the Fed to approve bank mergers on the basis of Community Reinvestment Act compliance produced trillions of dollars of risky mortgage originations by banks in the 1990s and 2000s. Knowingly or not, the Fed understated the risks and commensurate capital requirements associated with these mortgages.

What to expect from the new Fed
In response to regulatory over-reach, the partial loss of Fed independence and its politicization, expect the recast Board of Governors to push in 2018 and 2019 for the following changes:

  • The Fed will focus financial regulation increasingly on explicit objectives that relate directly to financial-sector performance.
  • The Fed’s regulatory authority will follow rules established by Congress and become increasingly subject to Congressional budgetary discipline. Clear rules will lead to greater discipline in the formulation and implementation of monetary and regulatory policies to insulate policy-makers from special-interest pressures and foster emphasis on long-run public policies.
  • More transparent regulatory standards will be formed and enforced, making regulators and supervisors more accountable to the public. Supervisors will remain vigilant to look for violations of the letter or the spirit of black-letter regulations despite the more relaxed regulatory stance.
  • The micro- and macro-prudential supervision of banks will continue, with special emphasis on avoiding micro-management of each bank’s business practices.
  • The elimination of the Fed’s holdings of agency mortgage-backed securities likely will occur at a faster pace than was outlined in the 2017 principles of balance-sheet normalization; this should extricate the Fed from direct incursion into fiscal-like policies.

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The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

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