How much politics can the Fed weather

This year the usual four voting FOMC members will be replaced. Given the annual rotation of voting rights, the monetary policy committee will in 2017 again be more strongly peopled by monetary policy doves who tend to advocate a cautious path to raising interest rates. The financial market expects to see two or at most three rate hikes. For this year, we expect that the Fed will raise its key lending rates twice and in each instance by 25 basis points.

The currently vacant seats on the Board of Governors could be seized by the incoming US President as an opportunity to gain influence on the Fed’s uppermost decision-making body relatively swiftly. Moreover, it is to be feared that he will neither extend the period in office of the Fed Chair Janet Yellen, which ends on 3 February 2018, nor approve another period in office for Fed Vice Chairman Stanley Fischer. By mid-2018 Trump could therefore have filled four of the seven seats on the Board of Governors and thus introduced politics into the monetary policy decision-making.

Another exciting point will presumably be whether Congress, spearheaded by the new president, succeeds in limiting the Fed’s powers. Many Republican members of Congress have for some time been calling for the Fed to make its decisions more transparent and for it to be more strongly subject to Congressional control. During this debate some have even gone so far as to suggest the Fed should only be allowed to change key lending rates in line with a certain response function, such as the Taylor rule. Monetary policy would then take place automatically.

In the medium term, the possible influence exerted by the US President could lead to a notable change in the thrust of monetary policy. And Congress could also be accorded tighter control rights. This would rob the Fed of some of its flexibility in responding to unforeseen circumstances, such as a renewed recession or even a crisis in the financial market or in the economy as a whole. However, the real problem here is that the Fed’s credibility would suffer, meaning that the crucial stabilising effect US monetary policy has on the financial markets would increasingly disappear. Neither the ECB nor the Bank of Japan could assume this function, as these institutions are likewise too closely aligned to daily politics.

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