US: Markets need to get familiar with Powell’s Fed – Danske Bank

In 2018, FX markets will have to start getting used to a ‘new’ and less experienced Federal Reserve, according to analysts at Danske Bank.

Key Quotes

“First, the Fed will have a new chairman from February: Jerome Powell, a non-economist (lawyer). Second, the Board of Governors has seen a major overhaul, with experienced members Janet Yellen, Stanley Fischer and Daniel Tarullo out and Randal Quarles, who is likely to be joined by Marvin Goodfriend, entering. Finally, New York Federal Reserve president William Dudley is set to step down next summer.”

“For FX markets, this has a wide range of consequences. First, the market should start from a blank sheet in terms of assessing the new members’ stance on monetary policy, including ways of communicating it. Second, until more vacant seats on the board have been filled, the balance of power within the Federal Open Market Committee (FOMC) will be with the regional presidents. The FOMC has a tradition of working by consensus, while the regional presidents have frequently dissented. Third, there is increasing uncertainty about the future framework for monetary policy in the US; for example, the level to which it will reduce the balance sheet, whether the Fed will continue to operate with interest on excess reserves and whether the voices advocating a price level target to combat persistently low inflation gain traction.”

“Pricing of Fed ‘inexperience risk premium’ ahead

• While it is not clear whether Powell’s inexperienced Fed will head in a more dovish or hawkish direction than was the case under Yellen, it certainly heightens uncertainty – and this matters for the FX market. Notably, we find significant evidence of a ‘Fed experience premium’ on USD over the post-Bretton Woods period since 1973 by relating the level of the dollar index to the combined years of experience of Fed Board members (controlling for the general monetary-policy stance).
• This essentially means the FX market has put a premium on USD in periods where the Board of Governors has consisted of members who have served over a long period and to whom markets have grown accustomed. This suggests that a ‘Fed inexperience risk premium’ could be discounted in the dollar next year as a result of a range of newcomers entering the Fed. As such, this is a caveat to the mechanical thinking that a Fed set to hike more than priced would necessarily support USD: mind the experience gap that Yellen and co leave behind and brace for USD weakness not least in the event of a shock, as the policy response may not be as swift – and hence USD positive – as in the previous decade.”