David Kotok is the chairman and chief investment officer of Cumberland Advisors. The views and opinions expressed in this piece represent only those of the author and not necessarily those of S&P Global Market Intelligence.
“Yet there is also good reason to worry,” wrote The Economist in a page 10 editorial dated February 1, 2018. We agree.
They made the case with this summary: “An independent central bank can be better trusted to act swiftly to curb inflation. That trust also gives it freedom to cut interest rates when the economy turns down. The kinds of problems set by a booming world economy and elevated asset prices are best tackled by experts at some distance from politics. What central banks need is not the appointment of officials who are less inclined to disappoint their political masters.”
Could the turmoil in the U.S. central bank’s composition and its interface with politics be one of the hidden ingredients that exacerbate market turmoil and worsen violent volatility? The answer may be yes.
Consider the evidence.
Our Federal Reserve functions without a full board of governors because of politics. The new chairman, Jay Powell, has two colleagues seated on a seven-member board. A third nominee is now in political trouble because a senator doesn’t like his views. The nomination of Marvin Goodfriend squeaked through the Senate committee on a partisan 13-12 vote. We shall see if he is confirmed or if he falls by the wayside. Three other vacancies on the board await nominations by President Donald Trump. So right now, the five voting Federal Reserve Bank presidents outnumber the three voting governors, and that is likely to be the situation for months. Some might argue that that ratio is a good thing, as regional bank presidents are selected by their banks and are not subject to Senate confirmation of presidential appointments.
Please note that this situation is not unique to Trump. It started under George W. Bush and continued under Barack Obama. Even in the midst of the worst financial crisis since the Great Depression, the Fed’s board of governors chaired by Ben Bernanke had two vacancies. In those days the board had a requirement for a supermajority of five votes to rule on an emergency action. So Bernanke had to live under a unanimity rule imposed by a U.S. Senate that was unwilling to confirm appointees.
Meanwhile, the Fed has the political problem of less-than-robust congressional objection to how the Congress raids the central bank. The most recent example was hidden in the budget deal. Christopher Condon of Bloomberg caught it and reported it in a story titled “Congress Raids Fed’s Surplus for $2.5 billion in Budget Deal.” Condon reported that the congressional raid on the Fed’s surplus reduced the Fed’s account to $7.5 billion and forced America’s central bank to send the money to the Treasury.
Please note that the Fed routinely sends any accumulated surplus to the Treasury, but this $2.5 billion was a sleight-of-hand maneuver by politicians to get the budget deal through. This transfer was not part of the regular remittances process. It means that those remittances will be reduced by $2.5 billion.
Congress previously pulled a fast one like this by raiding the Fed’s surplus to finance a highway spending program. And before that it forced the Fed to fund the Consumer Financial Protection Bureau. What is next? Can you imagine an emergency funding measure that raids the Fed for hurricane disaster relief or mosquito control or anything else on a list that could become open-ended? Remember that this type of raid bypasses the traditional budget-determined spending and taxing mechanism. It hides things from scrutiny. Only a journalist with skills can ferret it out and make it public.
Now, there is no way to put a numerical value on political risk to a central bank. We know it is there, but we cannot measure it in isolation. We can see the results after a shock. We can measure them after emergency funding actions like the Fed’s Maiden Lane bailout of Bear Stearns Cos. LLC during the financial crisis. But otherwise the precise cost of political interference with a central bank is elusive. We may see it reflected in some credit spreads, but there are multiple reasons for those to widen or narrow.
Market turmoil worldwide is raising volatility. Central banks’ exposure to politics seems to be part of the cause. In addition to the Fed, we are looking at changes coming to the European Central Bank. ECB President Mario Draghi’s term ends next year. The predictability of the ECB is lessened by this forthcoming leadership change, while there is still no confirmed path that market agents may rely upon for the ECB’s tapering to normal. Predictability is further worsened at the ECB because Vice President Vitor Constancio’s term ends in May.
Bank of Japan Governor Haruhiko Kuroda’s term is ending soon, too. He may be reappointed, or there may be a change as early as April. In China, the current governor is expected to retire. There are other large central banks looking at changes as well.
The bottom line is that political shenanigans and influence pose a continuing threat to central bank independence, and the outlook in the U.S. is worsening for the Fed’s independence. Is that adding to market volatility? We think so.