Wall Street’s faith in the Fed might soon be tested

Federal Reserve board member Jerome Powell speaks after President Donald Trump announced him as his nominee for the next chair of the Federal Reserve in the Rose Garden of the White House in Washington, Thursday, Nov. 2, 2017Pablo Martinez Monsivais/AP

• Federal Reserve turnover is unusually high, with four seats on the central bank’s board still awaiting presidential nominations.
• Many market participants welcome Jerome Powell, the new chair, as having market experience and signaling a degree of policy continuity with outgoing chair Janet Yellen.
• There are also fears, however, that the dwindling number of economics PhDs at the highest levels could hamper interest rate policy in coming years.

Wall Street is becoming a little too certain about the future path of US interest rates.

Markets welcomed President Donald Trump’s nomination of Jerome Powell to replace Janet Yellen at the central bank’s helm as a sign of likely policy continuity. In the short-run, it probably is.

But beneath the surface, an unusual level of turnover at the highest levels of Fed staff could have a considerable effect on the policy outlook, and even the way policymakers communicate with markets and the public.

The whopping stock market rally that began in March 2009 and continues to set records was built on large part in confidence in the Federal Reserve — its swift response to the financial crisis under the stewardship of Great Depression scholar Ben Bernanke, and the ongoing support of a low interest rate policy under Yellen.

But the future of Fed personnel is now uncertain. Trump still has four open board governor seats he could nominate, although he has been especially slow about filling the ranks of presidential appointees. At the same time, the influential New York Fed president post is up for grabs after William Dudley announced his early resignation, and the presidency of the Richmond Fed is also open after the prior president resigned in April due to a leak scandal.

All these changes could have big, if incremental, implications for financial markets, which have been counting on policy continuity from the Fed under Powell.

Powell, who unlike many of his predecessors is trained in law rather than economics, brings lots of financial market and policy experience to the job, having spent much of his career at the private equity firm Carlyle Group. He has now been on the Fed’s board as a governor since 2012, and was previously a Treasury official under George W. Bush.

“Different people have different areas of strength — what matters is the composition and quality of the FOMC as a group,” David Andolfatto, a vice president at the Federal Reserve Bank of St. Louis, told Business Insider.

The Fed is facing key decisions in the coming months and years, including whether to continue raising interest rates in an economy that has performed robustly but unspectacularly. Officials are torn between a historically low 4.1% jobless rate, which suggests underlying strength, and an inflation rate that continues to undershoot the official 2% target, which suggests on the other hand that the economy is actually operating below its full potential.

The recent spate of high turnover leaves open questions about how the Fed will handle those big decisions. Michael Pearce, US economist at Capital Economics, worries that a lack of economic expertise in the broader ranks of the FOMC “raises the risk of miscommunication or even a major policy mistake.”

In particular, Pearce wrote in a research note to clients that the number of FOMC participants with economics PhDs “peaked at 16 in 2003 and may fall to just half that by early next year.”

Yellen’s announcement that she will step down as board governor after Trump failed to reappoint her as Fed chair leaves “Lael Brainard as the sole member of the Board with advanced training in economics,” Pearce said.

“As far as we can tell, that would be unprecedented and at odds with other major central banks.”

The average tenure of the regional Fed presidents fell steadily over the 2000s, Pearce added, and resignations at the board have accelerated that trend.

“The average FOMC participant has spent less than four years in the position, half of what the average tenure was fifteen years ago,” he writes, offering the following chart to illustrate the point.

Capital Economics

Indeed, Goldman Sachs economists recently estimated this may be the biggest year of turnover for the Fed going as far back as 1936.

“A less qualified and experienced FOMC doesn’t affect the immediate outlook for policy,” Pearce concluded. “But it does mean that the big questions will fall increasingly to the Fed staff rather than FOMC members themselves.”