- Yesterday was a very eventful day, as Donald Trump struck a deal with the Democrats on Harvey aid, government funding until December and a suspension of the debt limit until mid-December.
- In our view, this is just kicking the can down the road, as we now risk a government shutdown in December and/or a government default at some pint early next year.
- Yesterday, the Fed’s Vice Chair Stanley Fischer announced that he will step down on or around 13 October, leaving four empty seats in the Board of Governors.
- The Wall Street Journal reports that President Trump is unlikely to nominate Gary Cohn as the next Fed Chair. This has increased the probability of the reappointment of Janet Yellen but Trump is known for wanting his own people in key positions.
- The many empty seats mean that it is difficult to say what direction the Fed will take next year. The Republicans may use the opportunity to shift the Fed in a more hawkish and rule-based direction.
Debt limit suspended until mid-December
Despite Republican House Speaker Paul Ryan saying that the Democratic proposal to suspend the debt limit for months was ‘ridiculous and disgraceful’, President Trump sided with the Democrats. This means that we now have a bipartisan deal on Harvey aid, funding for the government for three months and a suspension of the debt limit until mid-December. The deal came earlier than we had expected, as we thought (in line with Republican members of Congress) the Trump administration would be willing to fight harder for a longer lasting solution to the debt limit. Basically, the deal means the risk of a government shutdown has only been postponed from the end of this month to December. Republicans still need a budget for the fiscal year 2018 (lasting from 1 October 2017 to 30 September 2018), eventually allowing them to avoid filibusters in the Senate through budget reconciliation. However, the main problem for the Republicans remains the internal disagreement between the fiscal hawks and the more moderate Republicans. The former, unlike the latter, wants to make major cuts in fiscal spending.
While the suspension of the debt limit expires in mid-December, the stricter deadline is likely some months afterwards, as the Treasury can now ‘refill’ some of the extraordinary measures it has exhausted in recent months. This means there is still a risk of a government default at some point in 2018. It is not an option only to increase the Treasury’s cash buffer at the Federal Reserve, as it needs to be back at the current level when the suspension of the debt limit expires in mid-December.
The suspension of the debt limit also means that the US Treasury can increase its debt issuance again.
Vice Chair Fischer steps down, four out of seven seats are now vacant
In addition, Fed Vice Chair Stanley Fischer has written a resignation letter to President Trump due to personal circumstances. Fischer will step down on or around 13 October, leaving four vacant seats at the Fed. While this move caught everyone by surprise, most believed Trump would not reappoint Fischer anyway when his term expired in June next year, so markets barely moved on the announcement.
With four out of seven seats at the Fed Board of Governors currently vacant – and possibly soon five, as it is not our base case that Trump will reappoint Janet Yellen as Fed Chair (see more below) – Trump has the power to shape the Federal Reserve in the way he wants (although the Senate has to approve his nominations). This makes it more difficult to say what the Fed will do next year, as it is difficult to say in which direction the Fed will go. Trump has not said much about monetary policy but he has said a few mutually contradicting things: (1) he says he wants higher rates but is a ‘low interest rate guy’ and (2) he says a strong USD is a sign of strength but that a weak USD is good for US exports. In other words, it is difficult to say whether the Fed will turn more hawkish or more dovish, as Trump does not really seem interested in monetary policy, as he thinks of economic policy in terms of trade policy and tax reform/deregulation/infrastructure investments. While President Trump does not seem very interested in monetary policy and the Fed, the Republican Party certainly is, as many Republicans are dissatisfied with the Fed’s low-rate policy. Many Republicans want a more rule-based Fed, which bases its monetary policy decisions on a policy rule. Based on a simple Taylor rule, which links the Fed funds rate to inflation and unemployment, the Fed funds rate should be around 3% now. In other words, we might see a more hawkish and rule-based Fed next year but the uncertainty is high. For more, see what we wrote back in February: Research US: Trump to nominate three Fed governors – Tarullo resigns, 13 February. Overall, it seems fair to say, the Fed’s independence may come under greater pressure.
Trump has already nominated Randal K. Quarles, as former Treasury Department official, to serve as Fed Vice Chair for Supervision (see NY Times). Quarles is considered more dovish on financial regulation than Daniel Tarullo, who was previously in charge of supervision (at least in practice).
Trump’s economic adviser Gary Cohn was favourite to succeed Yellen as Fed Chair but The Wall Street Journal reports that Trump is unlikely to nominate him due to Cohn’s criticism after Charlottesville. According to PredictIt, the most likely scenario is now that Yellen will be reappointed but this is not our base case.