The fallout in the US dollar might be muted for the added fact that Taylor could still find himself on the FOMC in some capacity, with President still set to appoint three additional FOMC Governors – including a new Vice Chair to replace Stanley Fischer, according to Viraj Patel, Foreign Exchange Strategist at ING.
“Yet, the bigger question we’re asking ourselves is whether Taylor as Chair or Vice Chair would actually be game-changing in the long-run? Assessing his recent rules-based academic literature, there are there areas where we note Taylor differs from the Fed's current ideology: (1) his estimate of what the real neutral interest rate (r*) is; (2) QE as central bank policy tool; and (3) the role of the USD in the Fed policy reaction function:
- It’s highly unlikely that Taylor can single-handedly shift the FOMC's thinking on interest rates. From what we know, Taylor sees the real neutral interest rate (r* adjusted for inflation) at 2%. This is around 150-200bps more than what the Fed currently estimates; Janet Yellen in September noted that the real neutral interest rate in the US was ‘close to zero’ – and at best may slowly move higher over time. The question is whether Taylor – as Fed Chair or Vice-Chair – would be able to go in and convince the largely more dovish FOMC members that the assumptions that they've been using are wrong. This seems highly unlikely given that the concept of a time-varying r* has been a major development in central bank thinking since the crisis.
- Where Taylor may have greater success is through a quicker unwind of the Fed's balance sheet – and that poses upside risks to long-term US yields and the USD. It's clear that Taylor has been anti-QE, viewing it as a policy that has fuelled competitive devaluations globally. Fed officials overall may be less opposed to a slightly quicker run-off in the balance sheet – especially given its fairly impact on markets thus far. Moreover, Taylor's more free-market approach to capital flows and exchange rates means the USD would also move higher in this scenario.”
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