Monetary

Hawkish FED board in 2014? Maybe not

The FOMC will have new members in 2014. After the Senate approved Ms. Yellen’s nomination as FED Chair, other changes are upcoming including the rotation of regional bank Presidents and the vacancy replacement of Governors Duke and Raskin. President Obama announced that will nominate former Bank of Israel Governor Mr. Stanley Fischer to fill Ms. Yellen’s vacancy. Deputy Treasury Secretary Ms. Jael Brainard will also face Senate confirmation to fill Ms. Duke’s seat, while current FED Governor Mr. Jerome H. Powell will endure renomination after seating since 2012 for an unexpired term that ends in January 31st 2014.

Tom Essaye of the 7:00’s report wrote in Forbes Magazine that the board will turn hawk in 2014. I expect more hawkish members compared to the 2013 board but the median voter will likely continue a dove. Thus, I think there is a very high probability that the board will continue dove, but a hawkish stance should not be ruled out. It is almost certain that the FOMC will continue tappering, but I argue it will do so under the same pace that 2013 FOMC would have done it.  Let us see why and why that matters.

The FOMC follows a majority rule voting system. If we assume that Governor’s preferences can be summarized in one dimension of Hawk-Dove ideology (high-low inflation tolerance), then according to the median voter theorem, the expected outcome should be that of the median voter– that is, the ideology of the voter whose monetary stance lies in the median of all decision-makers’ preferences. Using this methodology, we can forecast the monetary stance (hawk-dove ideology) of all past and current FOMC board members according to their casted votes. The methodology also identifies the median voter and thus the ideology of the board at large.

Figure 1 shows the preferences (or ideal points) of the 2013 FOMC board. The ideological points represent where each of board members lied in the monetary-ideology spectrum (dove-hawk), based on their votes at the FOMC. The lines represent the statistical confidence at 95%. The figure shows that before Ms. Raskin and Ms. Duke left the board, the median voter lied somewhere in between Governors Stein and Duke ideal points (highlighted), although the ideological differences in the hawk-dove spectrum of 8 of the 12 FOMC members were  rather inexistent. Indeed, a board with shared pivotal positions.

Figure 1: 2013 FOMC board prior Duke and Raskin’s vacancy (January to July)

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After Ms. Duke and Ms. Raskin left the board, the median voter lied somewhere between Mr. Tarullo and Mr. Stein, which nevertheless is not statistically different from the prior median voter position. The median voter position is highlighted:

Figure 2: 2013 FOMC after Duke and Raskin left the board (September to December)

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The median voter should change in January’s Board.Boston FED Eric Rosengren, Chicago FED Charles Evans, St. Louis FED James Bullard and Kansas FED Esther George will leave the board as their rotational term expires. Rosengren and Evans were the most dovish members of the 2013 FOMC, while Ms. George was the hawkish voice according to our ideal point estimates (and in line with George’s anti-QE3 votes). Minneapolis FED Mr. Kocherlakota, Cleveland FED Ms. Pianalto, Dallas FED Mr. Fisher and Philadelphia FED Mr. Plosser will fill the rotational vacancies, which should shift the median decision to Ms. Yellen– who is slightly more hawkish than Mr. Tarullo and Mr. Stein but not statistically different to conclude that the board is now hawk (Figure 3).

Figure 3: 2014 FOMC prior Senate’s confirmation of Fischer and Brainard (January)

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After January the board MIGHT turn hawkish and there is a chance that hawkish Mr. Plosser will become the median voter.  We know that Obama will nominate Mr. Stanley Fischer, Ms. Brainard and renominate Mr. Powell. After the Senate changed filibuster rules for Presidential nominees, all three nominees should easily pass Senate’s inquisition. We do not know (yet) Mr. Fischer and Ms. Brainard’s ideological positions (or monetary stance), which leaves us with conjectures and assumptions about their positions based on public announcements and their background.

Without knowing both nominees’ ideal points, we can guess what could happen to the median voter in four possible scenarios: i) both Fischer and Brainard are hawks; ii) both are doves; iii) at least one of them is dove; iv) one is a moderate and the other a non-dove. Under scenarios i) and iv) the board turns hawkish.

Scenario 1: Both Doves. Dovish Board

If Fischer and Brainard’s ideal points locate somewhere to the left of Yellen (or more dovish than Yellen), the median voter will continue with the current dove stance. If they are more dovish than Stein (Figure 4), Stein would become the new median voter. If they locate between Stein and Yellen, then the new median voter would lie between Stein and Yellen which however is not statistically different. That is, two dove members would bring a dove board despite hawk bank presidents.

Figure 4: Dovish nominees means dovish board

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Scenario 2: Both Hawks. Hawkish Board. Plosser is the median voter

If both Fischer and Brainard are hawks–more hawk than Plosser– then the board would turn hawk as the median voter would shift from Yellen to Plosser. This scenario is somehow odd as it’s contra-intuitive that Obama nominates a Dovish Chair (Yellen) but nominates two hawks to make Plosser (and not Yellen) the median voter. I would say 5% chance this happens.

Figure 5: Hawkish nominees means hawkish board

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Scenario 3: At least one dove. Dovish board. Yellen continues as the median voter

If Obama decides to nominate only one Dove (that is, near Yellen-Stein’s ideology), Ms. Yellen will continue as the median voter regardless the position of the other member. The non-dovish nominee can be as hawk as Fisher– it wouldn’t matter– the median voter would be dove Ms. Yellen (Figure 6).

Figure 6: At least one dove and the board is dove

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Scenario 4: One moderate and one non-dove (either moderate or Hawk). Hawkish board (but how hawkish?)

If Obama nominates one moderate– someone between Yellen and Plosser’s ideal points– and one non-dove, then the median voter would lie between Yellen and Plosser and would correspond to the ideal point of the moderate new member. One moderate, but How moderate? The board would become more hawkish but with a high ideological room– it may turn just slightly hawkish (close to Yellen) or very hawkish (close to Plosser). If both members are moderate, then the median voter would be the most dovish of both.

Figure 7: At least one moderate and the board is hawkish. But how hawkish?

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So what?

This odd analysis should point towards a 2014 dove board. I see scenario 3 (at least one of the new boards is dove) highly possible. My bet would be that at least former Deputy Secretary of the Tresury is more dovish than (or as dovish as) Ms. Yellen, as it should be very likely that President Obama asked Yellen’s advice on who to nominate and thus Ms. Yellen should have presumably advised to nominate someone close to her ideal point. That should rule-out Scenario 2 (hawk board) but not Scenario 4, which I think should be the real risk scenario.

There is literature that suggests that monetary boards– specially monetary Chairs– hate disagreement. Under that story, the FOMC should turn hawk regardless the median voter’s position as Ms. Yellen would avoid confrontation with her hawk peers. There is not statistical evidence to proof or reject that assumption, but from my roll call database it is true that disagreement is rather uncommon in the FOMC but it is also true that it depends on the Chairperson’s leadership— if she prefers to maintain congeniality or to pursue her ideal point. That is something that needs to be addressed further.

President Obama still has to nominate Ms. Raskin’s replacement while rumors indicate that dove Mr. Stein will leave the board to Harvard on May. Let’s touch base on March.

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Forecasting why Yellen is Bernanke 2.0

After Yellen’s confirmation hearing, most market analysts were surprised how future chairwoman Janet Yellen managed to use the same contingent-dovish language as predecessor chairman Bernanke.

Jeffersons’ umbrella Fund US Economist mentioned in a note to clients (taken from BBC):

“As expected, Janet Yellen has been a defender of an accommodative monetary policy, and sounded remarkably like Ben Bernanke on key current issues,”

Zero Hedge blog tweeted:

6 out of 5 Wall Street economists agree: Yellen is Bernanke 2.0

In a research paper I wrote while at The University of Chicago, I forecasted the ideologies of all FED members that have seated at the FOMC since 1936 until 2013 (October). The results pretty much are in line with market analysts now take as a fact: Yellen is Bernanke 2.0
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The results also cast how an average Democrat appointive FED is more dovish than a Republican, how Volcker is an inflation Hawk compared to almost all FED governors and how both Yellen and Bernanke are doves.
Other market analysts have made bets about who is a hawk and who is at the current FED. Thomson Reuters’ “monetary ideology” forecasts cast relatively similar to my results, with a correlation of 0.4 once rescaling. The difference arises in how one method is subjective and based on intuition, while the other is objective and is based on policy decisions and votes. For example, Reuters’ does not account Kansas City FED Esther George as hawk (while I do), despite that she has been consistingly voting against maintaining QE3.
The results also cast past ideologies of the mean board, showing how the current board is as dove as it gets. The mean monetary ideology of the current FED is the most dovish that has ever seated since 1936. Here they correlate with output gap and CPI inflation.
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During Eccles’s chairmanship an ideological recomposition was observed inside the period FOMC , where in 1936-1940 the average board was relatively hawkish, with inflation below 2% and an economy just coming out of the 1930 crisis . This seemingly contractionary position is in line with Friedman (1963), who explained the Great Recession from the monetary point of view with a Fed that limited broad base money without supporting the needs of the product. Later in the period 1945-1950 there’s a recomposition supporting the product , tolerating higher inflation levels and achieving a positive GDP gap in 1950.

Subsequently, Governor Martin 1950-1970 period was characterized initially by a less expansive ideological position, managing to keep inflation under control and taking the positive output gap to neutral levels. The change in the ideological position coincides with candidate R. Nixon complain, who argued that the Republican Party lost the presidential election in part by the position contractionary FOMC members under Governor Martin.

In the second part of the mandate of Governor Martin 1963-1970, we note the change in the ideological position with the arrival of new members to the FOMC. Thus, in this period the average ideological position is more expansive than that of 1957-1963 , which is related to an increase in inflation and output gap positive historically . The ideological shift coincides with the arrival to the presidency of Democrat Lyndon Johnson .

The mandate of Governor Burns seems to recover a contractionary ideological composition , partially moderating the inflationary pace and reducing the output gap. The mandate of Miller , although brief , is not clearly related to the high increase in inflation. Ideological estimates fail to predict the inflationary shock after Volcker was elected FED Governor.

The mandate of the Governor Volcker , mainly in its second stage of 1985-1989 , suggests a contractionary ideological position that is related with a reduction in inflation under the sacrifice of a negative output gap . Greenspan ‘s mandate is neutral on average , with a very slightly expansionary ideology that averages -0.04 between 1989-2005 which is affected by the position yet expansive under the Clinton administration and the appointment of Governors elected by the then President. The relatively neutral position is related with inflation very close to the target of 2 % during the term , and initially negative output gap that achieves located on neutral ground in 1997 and remains close to that level , with some cyclical variations .

2005-2013 Bernanke administration has introduced some changes in its composition , but maintaining as the most ideologically expansive in the history of the Fed. This goes in line the post- crisis period where the FOMC has kept its benchmark rate at expansive levels (0.25%) with an unprecedented easing ( QE1 through QE3 ) a largely negative output gap and inflation recently below the goal of 2 %. Ideological estimates find that a contractionary FOMC board as that seen in 1937 or Martin’s FED, would not have supported output with equal forcefulness. It was only with a board ideologically as expansive as the current that output has managed to received an extensive monetary support.

Regarding polarization, it seems that unlike Congress, polarization keeps outside the FED. Despite the average democrat is a dove compared to the average republican, their views change along with the cycle, and seem independent from growing congressional polarization and income inequality.
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A summary of the document will be published next month at ANIF’s Carta Financiera.

JCS:.