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How Will the Fed Evolve Under Trump? 

 

 

Steve Malin

4/25/2017 

Beset with low rates, slow growth and a new US president who wants a significant shift in policy, Steve Malin says the Federal Reserve faces one of the most uncertain periods in its 104-year history. What could a changing Fed mean for investors.

Key Takeaways

  • President Trump will have several opportunities to appoint Fed governors who favor policy in line with his administration's goals
  • Although the Fed could encounter unprecedented oversight by the executive branch, its independence won't be entirely eroded
  • A newly revamped Fed may elevate rates as quickly as economic conditions allow – perhaps as high as 4%
  • The Fed has preannounced its intention to unwind some of its holdings, which should minimize market disruptions
  • New Trump appointees could relax enforcement of existing regulations, roll back others and guide the withdrawal of the US from some international banking standards

Changes afoot at the Fed

A complete revamping of the Fed will start to play out over the next 12 to 15 months
The election of President Donald Trump has already had significant implications for many US institutions – from the Supreme Court to the Department of Education – and the Federal Reserve is next in line. A complete revamping of the country's central bank will start to play out over the next 12 to 15 months.

During that time, the Federal Reserve Board will likely welcome five or six new governors, implement new approaches to monetary policy, take a looser regulatory stance, reduce its portfolio of assets and potentially encounter unprecedented oversight by the executive branch. Taken together, these shifts in direction will provide an important reminder that while the US central bank is "independent within government", as it is often described, it is not "independent from government."

The Fed will likely welcome five or six new governors and implement new approaches to monetary policy
Existing legislation empowers Mr. Trump to appoint Fed governors who favor policy adjustments that are in line with his administration's goals – and he will certainly have several opportunities to do so. By stacking the Fed's Board with like-minded governors, Mr. Trump can weaken the Treasury-Federal Reserve Accord of 1951, which freed the central bank to formulate monetary policy regardless of the wishes of the president.

At the same time, the Fed's independence from political interference will not be entirely eroded. The Fed will likely take symbolic actions that add to the transparency of its operations, and unless new legislation is enacted, there should not be meaningful changes to the structure of the Fed system.

Investment implications of a new Fed

1.
Faster and higher interest-rate hikes. New Fed governors will likely resemble other Trump administration officials – for example, business executives who dislike excessive regulation. We also expect the next Fed Chair to favor a strict, rules-based approach to monetary policy formulation and implementation. This is a marked departure from the view of current Fed Chair Janet Yellen, who vigorously opposes such an approach. Given that most of the current 17 members of the Federal Open Market Committee believe US interest rates are too low to stimulate enough real economic activity, a newly revamped Fed may elevate rates as quickly as economic conditions allow. Rules-based models suggest that the FOMC could feasibly raise interest rates to 4% soon. Investors may want to consider factoring this forecast into their asset allocations – particularly given that many bonds lose value as interest rates rise.
Recent hints by FOMC members suggest that they will reduce holdings of both Treasuries and mortgage-backed securities
2.
A shrinking Fed balance sheet with limited market disruption. The weighted average maturity of the Fed's balance sheet has shrunk considerably since its peak in January 2013. Although it is unlikely that the Fed's portfolio will be reduced to its pre-financial crisis levels, we expect the Fed will begin unwinding its positions later this year as the federal funds rate approaches its target level. Recent hints by FOMC members suggest that they will reduce holdings of both Treasuries and mortgage-backed securities. Investors may be reassured by the fact that because the Fed has preannounced its intentions, it is unlikely that these portfolio reductions will significantly disrupt the markets or have an outsize effect on interest rates.
3.
Reduced regulatory burdens to spur growth. The resignation of Governor Daniel Tarullo, the Fed's head of supervision and regulation, enables President Trump to nominate a successor who will relax enforcement of existing regulations, roll back others and, perhaps, guide the withdrawal of the US from some international banking standards. Look for the Fed to either withdraw from Basel IV capital standards negotiations or, at least, to attempt to impose US-favored rules. Other international standards covering leverage, solvency and liquidity could be modified or put at risk. This may mean that small regional and community banks can look forward to diminished regulatory burdens. This could give them more scope to lend money to local businesses, which could in turn spur some economic growth.




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. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.



Allianz Global Investors Distributors LLC, 1633 Broadway, New York, NY 10019-7585, us.allianzgi.com, 1-800-926-4456.

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