Fed's Structural Dovish Orientation: Why Trump May Not Need to Rock the Boat

Key points:

• In 2020, the Fed shifted focus to employment shortfalls, ignoring deviations to the upside.
• Flexible average inflation targeting aims at inflation overshoot asymmetrically.
• The Powell Fed has already become structurally dovish.
• Trump might not need to take drastic action to change the Fed.
• The current monetary strategy framework has an inflation bias.

Trump's Potential Return and Powell's Future

The political landscape in the United States is once again buzzing with anticipation as former President Donald Trump emerges as a strong contender for the 2024 presidential election. As the possibility of his return to the White House looms, attention has turned to his potential impact on one of the nation's most crucial economic institutions: the Federal Reserve.

Trump's tumultuous relationship with the Fed, particularly with its current chairman Jerome Powell, has been well-documented. During his previous term, Trump was vocal in his criticism of the Fed's monetary policy decisions, often expressing dissatisfaction with interest rate hikes in 2017-2018 and what he perceived as allegedly belated and insufficient rate cuts in 2019. This contentious history has set the stage for potential changes in Fed leadership and policy should Trump secure a second term.

With Powell's chairmanship set to expire on May 23, 2026, and his term as a governor ending on January 31, 2028, Trump has not minced words, threatening to not only decline Powell's reappointment as Fed Chair but also hinting at the possibility of prematurely terminating his roles at the Fed. The Fed Chair is nominated by the US President from among the Fed governors and requires simple majority approval from the Senate. Fed governors are also nominated by the US President and confirmed by the Senate. The next governor whose term expires is Adriana Kugler, who was nominated by Biden to the Fed in 2021, on January 31, 2026. Trump could replace Kugler with his candidate for the governorship in January 2026 and then appoint him or her as Chair in May 2026. Names of prospective candidates include Kevin Warsh, a former banker at Morgan Stanley appointed by President George W. Bush as a Fed governor from 2006 to 2011. Warsh was on Trump’s final list of prospective nominees for the top job at the Fed in his first presidential term, but Trump ultimately selected Powell. Another name mentioned by Trump advisors is Kevin Hassett, who was Trump’s Chairman of the Council of Economic Advisors during his first term.

The Fed's Independence: A Delicate Balance

Adding fuel to the fire, Trump's advisors have floated ideas of requiring the Fed, under new leadership, to consult with the president on monetary policy decisions—a move that would significantly erode the central bank's widely perceived independence. Exerting influence during private meetings or via public statements is one thing; institutionalizing such subordination of the Federal Reserve to the White House is another and is extremely unlikely to be endorsed by Congress. The Fed’s power comes from the Federal Reserve Act of 1913, which grants the Fed operational independence subject to the scrutiny of Congress, not the White House. The negative impact on the financial markets, particularly the bond market, would also deter Trump and his advisors from turning this campaign rhetoric into action.

The 2020 Shift: A Structural Dovish Orientation

Among all these debates, a closer examination of the Fed's amendment to its Statement on Long-Run Goals and Monetary Strategy initially adopted in 2012 (the “2012 Statement”) released on August 27, 2020 (the “2020 Amendment”), reveals that Powell’s Fed may have already shifted from a symmetric policy framework to both inflation and employment to an asymmetric policy framework that focuses on employment shortfalls only, not deviations to the upside in employment. It also aims to achieve inflation moderately above 2% for some time following disinflation periods without symmetrically committing to bringing inflation below 2% following high inflation periods.

To illustrate the difference between the Fed’s policy framework before and after August 2020, consider the relevant excerpts from the 2012 Statement and the 2020 Amendment reaffirmed in January 2024:

2012 Statement: “…The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate…In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level…”

2020 Amendment: “…the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level…the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time…In setting monetary policy, the Committee seeks over time to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal…”

Implications of the Structural Dovish Bias

It is important to note that the 2020 revision was reaffirmed in every subsequent January and most recently in January 2024. In other words, even after the year-over-year change in the Price Index of Personal Consumption Expenditures, the inflation measure specified in the 2012 Statement and 2020 Amendment has been above 2% for well over three years since March 2021 till the present, the Fed has not further amended the Statement. This arguably has made the Fed structurally dovish, allowing employment to run above its estimated long-term potential and inflation to stay above 2% for an extended period without committing to bringing inflation below 2% to achieve the long-term average of 2%. According to Powell, as stipulated in his Testimony to the Senate’s Committee on Banking, Housing, and Urban Affairs on July 9, 2024, the Fed will start cutting rates once it has “gained greater confidence that inflation is moving sustainably toward 2 per cent”. It is important to note that it is “toward 2%” that is above 2%, not below 2%.

In 2017 and 2018 when Trump complained that the Fed was hiking rates, the unemployment rate was falling and hit 3.6% in September 2018, while the change in the Price Index of Personal Consumption Expenditures reached 2% year-over-year (Y/Y) in March 2018 and stayed above 2% Y/Y until October 2018. Working under the guidance of the 2012 Statement, the Powell Fed had little choice but to continue to hike rates.

Powell’s shift, implemented in the 2020 amendment, was too late for Trump in his first term, and Trump might still seek to replace him if he returns to the White House next year. However, since August 2020, the Powell Fed has already become structurally dovish and Powell is not Paul Volcker. Eggertsson and Kohn (2023) and Levy and Plosser (2024) suggested the strategy adopted by the Fed since 2020 has delayed the Fed’s response to the surge in inflation in 2021. Likewise, according to estimates from Bocola et al. (2024), inflation would have peaked at about 5% in 2021 instead of rising to as high as 7.1% for the headline PCE deflator, the chosen measure of the Fed’s flexible average inflation targeting, if the Fed had not shifted to the new strategy framework in 2020.

The 2024-2025 Strategic Review: A Critical Juncture

As we approach the second half of 2024, the Fed is set to embark on its scheduled five-year review of its strategic policy framework that shapes the policy guidelines set out in the 2020 Amendment. The timing of the review later this year and the adoption of changes, if any, in 2025 fall into a time of transition into a new administration, potentially headed by Trump. It is very unlikely for Powell to unwind any of the dovish-oriented changes adopted in 2020. Given these developments, there is a strong argument that Trump may not need to pursue dramatic changes to the Fed's leadership or operational independence if he returns to office. The current framework already embodies many of the policy preferences he hoped to get during his first term. If anything, he might try to exert some influence during the review of the Fed’s strategic policy framework to his liking.

The Fiscal-Monetary Nexus and Inflation Risks

In our article “Is This Time Worse than WWI and WWII?” published three weeks ago, we raised the plausibility that US inflation may rebound to substantially higher levels in the coming few years due to the lack of plans or even credible intentions to bring down the elevated federal fiscal deficits. Whether it is Biden or Trump, the fiscal outlook and therefore the trajectory path of inflation look dire. In today’s article, we examine the issue from the monetary angle and conclude that there has been a structural inflationary bias in the Fed’s monetary policy strategy framework since 2020. Whether Biden or Trump sits in the Oval Office next year, we conjecture that a structural inflationary bias persists.

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