Did Donald Trump just make a sensible decision?

Janet Yellen should have been re-confirmed. But the choice of replacement could have been so much worse.

Donald Trump recently announced the new Chair of the Federal Reserve to replace Janet Yellen – Fed Governor Jerome Powell. And the collective economists’ reaction appears to be one of relief. Not because it was the best possible choice, but because the choice could have been so much worse.

To be honest, there doesn’t seem to be any reason why Janet Yellen couldn’t have been confirmed for a second term. In fact, Fed Chairs in recent history have served at least two consecutive terms. And Yellen, by all accounts, has done a great job. She has continued the process of normalising interest rates in the US – faster than some, including Nobel Prize winning economist and New York Times columnist Paul Krugman, would have deemed ideal, but not drastically so. And she has laid the path for the future normalisation of the Fed’s enormous balance sheet.

Yellen was chosen by Obama, and was the first woman to Chair the Fed, but I’m sure these facts had no bearing on Trump’s decision to replace her.

So the choice to replace her at all didn’t seem ideal. But the choice of Jerome Powell was such a relief because of the other candidates that were in the running.

Both former Fed Governor Kevin Warsh and academic economist John Taylor were two such candidates. Taylor you may recognise as the name behind the famous ‘Taylor’s Rule’ of interest rates – a formula he devised in 1993 using data relating to unemployment, inflation and potential output to generate an estimate of the current interest rate that the Fed should be targeting. The Fed didn’t follow this rule explicitly but, during normal times, this formula functioned quite well.

During the GFC however, Taylor’s formula seemed to suggest that Fed Chair at the time Ben Bernanke and Co. had dropped interest rates too far and flooded the market with too much liquidity. Many very influential and supposedly learned people, including John Taylor, all proclaimed in their now infamous 2010 open letter that the Fed’s actions would result in runaway inflation and the debasement of the US currency. Warsh made similar claims. Claims they maintained year upon year, and which never materialised. Bloomberg tracked down all these signatories in 2014 and still none of them conceded that they were wrong – that during a crisis like the GFC, extreme liquidity measures are indeed required, and will not produce runaway inflation or the debasement of the currency.

For the last decade, inflation has, in fact, remained stubbornly below the Fed’s 2% target. This is because, as mentioned in one of my previous blogs, this liquidity was not being spent/absorbed by the system – it was simply acting as a floor through which the system couldn’t keep spiralling. This is the nature of a ‘liquidity trap’, where a Central Bank can create the floor, but not the recovery – that requires fiscal support.

Were either of these two to become the new Fed Chair (or worse, had they become the Chair during the GFC), they very likely could have withdrawn liquidity from the system and raised interest rates in the face of these false prophesies, and in so doing, driven the fragile US economy properly into Depression 2.0. And I do not believe I am exaggerating in this assertion. Nor did I think that the Federal Reserve – perhaps the most powerful economic agency in the world and one of the last (at least quazi-) independent bastions of intellectual rigor and competence in the US – was immune to being, as Paul Krugman put it, “Trumpified”.

Then came the relief – Jerome Powell. Powell has been a faithful supporter of Yellen’s policies on interest rates and financial regulation over the last few years, and is likely to be a steady hand in the future. And while I would have liked to see Yellen for another four years, we can take comfort in the fact that Powell is not likely to normalise interest rates or the Fed balance sheet faster than the economy can handle, and that the Fed is in the hands of an experienced Chair who hasn’t been consistently wrong about monetary policy for the last decade.

Every cloud …