A recess-ion at the Fed?

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This is why I didn’t major in political science

If you are not familiar with the arcane rules of the US Senate, this is a good time to learn. The Constitution creates a number of checks and balances, including having the Senate approve Presidential nominations for senior jobs. This applies not only to cabinet members but also to Fed Governorships. Alexander Hamilton argued that Senate confirmation is “an excellent check upon a spirit of favoritism in the President and would tend greatly to prevent the appointment of unfit characters.” This quote isn’t drawn from some lefty publication, but from the op-ed page of the Wall Street Journal.

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However, there is a loophole. Because of the difficulty of Senators going back and forth to Washington at the time of the Constitution, the President is allowed to temporarily (for up to two years) appoint someone if the Senate is in recess. Today, the Senate is in session much more often and the majority leader can always declare a pro forma session to prevent a recess appointment. In recent years, both sides have been gaming the system. The minority party sometimes holds up candidates for political rather than competence reasons. The majority party sometimes uses recesses to push through unpopular candidates.

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Trump is now pushing for all his nominees to be approved by recess appointment, bypassing the Republican-controlled Senate. He wants the majority leader to put the Senate in recess early next year so that he can then appoint all the candidates immediately through the end of 2026. Of course, this exercise could be repeated any time one party controls both the White House and Senate.

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Currently the focus is on Trump’s immediate appointments, including his cabinet members. However, recess appointments can be used for many other jobs including Fed Governors. Monetary policy is decided by the seven members of the Board of Governors and five regional Presidents. In the extreme, as Governor terms end or they move on to a new job, the FOMC could have a majority of members (7 out of 12) that are chosen based on loyalty to the President.

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Good advice

In Trump’s first term, the Senate played an important role in screening potential Fed Governors and the process worked quite well. Strong “technocratic” candidates like Quarles, Clarida, Waller, Bowman and Powell (for his reappointment) made it through the process. By contrast, weaker candidates like Stephen Moore, Judy Shelton and Hermann Cain did not. As a result, the institution has remained strong and independent.

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Let’s take a quick look at the three candidates that did not survive the vetting but could circumvent vetting in the future. Stephen Moore is a leading advocate of much lower taxes and has worked closely with Republican Administrations including Trump. However, his nomination triggered a lot of red lights. He called for higher interest rates when the economy was recovering from the Great Recession under Barack Obama, but then called for lower rates when the economy was strong under Donald Trump. He favored a return to the gold standard and in February 2019, just before Trump floated him as a nominee, he said "There's no bigger swamp in Washington than the Federal Reserve Board. It's filled with hundreds of economists who are worthless, who have the wrong model in their mind. They should all be fired and they should be replaced by good economists."

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The other problem with Moore — and something we should watch for with other potential nominees — is that he is an extreme “supply-sider.” Why is this important? When the government cuts taxes it can stimulate both aggregate supply and aggregate demand. On the supply side, lower tax rates can stimulate labor supply and productivity, boosting potential growth particularly if it is designed to be deficit neutral. However, the consensus in economics is that the demand-side impact of tax cuts usually dominates. In Stephen Moore’s world, tax cuts pay for themselves, have little if any impact on the deficit and create a supply-driven boom. If correct, the tax cuts would warrant supportive rate cuts from the Fed. In reality, this combination of easy monetary and fiscal policy would be highly inflationary.

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Hermann Cain did not have the training — in economics, banking or financial markets — that a Fed Governor should have. More importantly, he was also a close political ally of the President. Like many economists, I was very worried that he would go along with Trump’s demand for persistently low interest rates. Not surprisingly, the Senate gave him a cool reception and he eventually withdrew from the process.

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Judy Shelton is the most interesting of the three. Prior to her work in the Trump administration, she was also a strong advocate of a return to the gold standard. Ironically, under the gold standard the central bank does not have power to regulate the economy, and hence cannot deliver low interest rates for the President. During the gold standard the economy was marked by very frequent recessions, and bouts of deflation. She also compared the Fed to central planning in the Soviet Union. Wikipedia has a good summary of her many problematic views on the Fed.?

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Like Moore, she favored tighter monetary policy when Obama was President and looser monetary policy when Trump was President. This suggested to many observers, including several Republican Senators, that she was not fit to be a Fed Governor. Indeed, Shelton triggered a petition from 130 economists, including seven Nobel Prize winners and many former Fed officials, calling her views “extreme and ill-considered.” Again, she was unable to make it through the process.

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In sum, I think it is important that Fed Governors first loyalty is to the Fed’s dual mandate, that they respect the institution, have a sensible economic framework and do not vote differently depending on who is in the White House. As we saw with Trumps four successful appointments, there are plenty of Republican-leaning candidates that fit that description.

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Turnover on the Board

Currently there are no openings on Board (Table). Only three Board roles come up for renewal in the next four years: (1) Powell’s second four-year term as Chair ends in May 2026 (although he could stay on as a Governor) (2) Barr’s position as Vice Chair for Supervision comes up in July, 2026 (he too could serve on as a Governor) and (3) Kugler’s term as Governor is also up in 2026.? However, as the table also suggests, Governors usually do not serve out their whole term so other openings are likely. The good news is that the appointment process for regional Presidents seems to have remained effective. Hence, the downside risk is for a politically compromised Chair, but still a majority of technocrats on the FOMC.

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Fed independence is important

In my last post I wrote about how policies that discourage aggregate supply (such as “mass deportations”) and raise aggregate demand (such as deficit-financed tax cuts) will likely add to inflation and end Fed rate cuts. I would then expect strong political pressure on the Fed to hold steady in the face of high political pressure to keep cutting. Powell knows that bending to pressure could only mean more pressure and that ultimately the Fed will take the blame for letting inflation come back.

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Appointing politically motivated governors adds to the upside risks to inflation over the medium term. As Fed Chair William McChesney Martin quipped, the task of the Fed is "to take away the punch bowl just as the party gets going.” What happens if the chaperon works for the liquor store?

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Overly easy policy and persistent inflation is only one of the risks. Even more concerning is how compromising Fed independence could impact the special role the US plays in global capital markets. Both the dollar’s reserve currency status and the central role of the Treasury market in capital markets could come into question. This special status is great for the US economy as it allows the US to borrow at very low rates in global markets. It also means that during crises capital tends to flow into the US rather than out of the US, cushioning the shock to the economy. Putting in a politically compromised Chair could be the trigger for losing that special status. We will learn a lot about the risks to Fed independence in the next few months.