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Feb 14, 2017 | 09:00 GMT

4 mins read

The Fed's (Possible) Political Makeover

The Fed's (Possible) Political Makeover
(ELIJAH NOUVELAGE/Getty Images)
Summary

Over the past four decades, the U.S. Federal Reserve has steadily gained power and independence in its policymaking. Each of its last four board chairs — Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen — has enjoyed considerable freedom to make his or her mark on the U.S. economy, for better or for worse. Volcker's campaign to bring the U.S. inflation rate down during the early 1980s facilitated two recessions. Greenspan spent nearly two decades as Fed chairman during the period that came to be known as the "Great Moderation," which continued until the 2007-08 financial crisis brought it crashing to a halt. Then Bernanke picked up the pieces in the wake of the crisis, instituting the controversial quantitative easing policies that have characterized much of the past eight years. In the process, the Fed transcended its traditional role to maximize employment and stabilize prices and took on what Yellen has dubbed the "unwritten third mandate": promoting financial stability and limiting systemic risk to the U.S. economy through regulation and supervision.

But the Fed's days of independence in policymaking may be numbered. On the campaign trail, U.S. President Donald Trump wasn't shy about criticizing the Fed's activities, and he, along with Republican lawmakers in Congress, likely intends to curtail the central bank's authority. The next year will present him ample opportunities to overhaul the Fed as he sees fit. Yellen, who will testify before Congress on Feb. 14-15 for the first time since Trump's inauguration, is now in the last year of her term as Fed chair. And by the time the president names her replacement, he may already have made four or five appointments to the Fed's board of governors.

Trump has been on a collision course with the Fed since long before he took office. During his campaign, the president criticized the system's Federal Open Market Committee, which sets monetary policy and interest rate targets. He even went so far as to accuse the Fed of keeping interest rates low in the runup to the elections to help his opponent, Democratic Party candidate Hillary Clinton, an allegation Yellen quickly denied.

Clashing Views

Now that Trump is in office, he likely hopes to bring the Fed's policies more in line with his own, lest they undermine his objectives. The president has pledged to draw investment to the U.S. manufacturing industry, reduce the country's import consumption and boost its exports. But the Fed's current policy trajectory threatens to derail these initiatives. For instance, the institution is expected to raise interest rates two or three times this year as it enters a monetary tightening cycle. Doing so, however, would further strengthen the dollar — which is already stronger than it has been in more than a decade (too strong, according to the president) — much to the detriment of Trump's economic plans. The Trump administration has argued that countries such as Germany, Japan and China have taken advantage of their comparatively cheaper currencies to boost their exports to the United States. And after a meeting with Japanese Prime Minister Shinzo Abe on Feb. 11, Trump announced that the currencies of China, Japan and the United States would soon be on "a level playing field," perhaps hinting that another global currency revaluation is nigh.

The Trump administration also intends to limit some of the Fed's freedom, particularly where introducing and enforcing regulations are concerned. On Jan. 31, the vice chair of the House Financial Services Committee — one of the two committees before which Yellen will testify — sent the Fed chair a letter urging her organization to stop negotiating with other countries over international regulatory standards. A few days later, Trump signed an executive order kick-starting his review of current financial regulations and oversight procedures. This process could eventually lead to a partial repeal of the Dodd-Frank Act, a bill passed in 2010 that imposed an array of new regulations on the U.S. financial sector.

Filling in the Gaps

Already, these actions seem to have caused a stir in the Fed. One of the system's governors, Daniel Tarullo, tendered his resignation Feb. 10. Since joining the Federal Reserve Board in 2009, Tarullo has led the effort to regulate and administer oversight mechanisms, including stress tests for banks. His resignation, effective in early April, will create a third vacancy on the seven-member board for Trump to fill. The open seats — and especially the vice chair of bank supervision post — will enable Trump to quickly transform the Fed in keeping with his ideas on deregulation (though the Senate could slow the process during confirmation).

Still, without Yellen's approval, Trump can take his plans to remake the Fed only so far. Although the Federal Reserve System is a massive entity in which non-appointed employees often play as essential a role as governors do, the chair has final say over much of its policy. Until Yellen's term ends in February 2018, Trump will likely focus on filling the board's vacant seats with governors who are more sympathetic to his goals, with an eye to eventually installing one of them as chair. Afterward, Yellen and perhaps her vice chair, Stanley Fischer, may decide to resign from the Fed — as is customary at the end of a turn at the board's helm — freeing yet more seats for Trump to fill.

Trump is poised to leave a lasting mark on the Federal Reserve System, perhaps changing the way it interacts with the government going forward. Not since Richard Nixon's administration has the system's governing board set its policies and determined its actions with politics in mind, and in the intervening decades, its strength and autonomy have grown. But the independence and apolitical approach on which the Fed prides itself may fall by the wayside as Trump pursues his own policies. 

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