Tuesday, November 3, 2009

Three Fed Officials to Watch

As the economic recovery slowly starts gaining some credibility, the financial markets' favorite guessing game is poised to become the timing of when the Fed will start tightening policy. Although some dialing down of a number of the emergency liquidity programs has already been occurring quietly in the last few months, the prospect of a rate hike and aggressive draining of reserves from the banking system would understandably represent a more decisive stage of the tightening process, and, as such, raise a higher level of anxiety among market participants. It was in that context that the New York Fed felt compelled to issue an unusual clarification last month to the effect that although they are already examining closely the mechanics of how the draining of liquidity will be achieved when the time comes, this should not be interpreted as suggesting that any decision has been made as to when this might happen.

Against that backdrop, statements made by various Fed officials in the next couple of months will be scrutinized closely for any hints of an upcoming change in monetary policy. Given the financial markets' notorious propensity for overreaction to just about anything, it is quite possible that some of these statements, while expressing, in many cases, simply the personal views of the FOMC member, will be misconstrued as a hidden message to the markets and can cause an undeserving degree of noise.

It is fair to argue though that, inasmuch as all voting FOMC members are technically equal, some members are more equal than others and their views carry a significant amount of weight in terms of providing hints about the likely inflection point in interest rate policy. Other members' views are immensely less important in that regard, as they often express personal biases that may not be shared by the majority within the Committee.

At the top of the list of Fed officials whose views really matter is obviously Ben Bernanke himself. His comments, as always, deserve a close degree of scrutiny in the period ahead, as he is certainly in a position to steer a number of other FOMC members that may have less strong conviction on the issue to his camp of thinking. He also has more high profile opportunities than any other Fed official to express any subtle changes in his thinking regarding the assessment of the economic recovery and the need (or, lack of thereof) to maintain the near-zero interest rate policy of the last 11 months.

The other two Fed officials that should be presumed as expressing the mainstream Fed view on policy are Vice Chairman Don Kohn and New York Fed President Bill Dudley. Don Kohn is an old hand at the Fed, a true product of the system and his views tend to adhere very closely to the "official" view at the institution (which should be taken as including Ben Bernanke's as well). Given his role as a semi-official statesman within the Federal Reserve System, he often feels subconsciously restrained to avoid veering far from the Chairman's official thinking. Although, prior to his appointment as Vice Chairman at the Fed, he had expressed views strongly skeptical of the concept of inflation targeting (which Bernanke was openly advocating), there have been no instances in the last three years or so where he has deviated from the Fed "party line".

Given the special role that the New York Fed occupies within the Federal Reserve System, its President has historically been viewed as always closely aligned with the Chairman of the Fed and Bill Dudley is no exception. He has loyally preserved that tradition since his appointment in that position in January of this year and in his public speeches, he always offers an eloquent and unapologetic defense of official Fed policy, using arguments that are often identical to those that Bernanke is making in his own appearances.

In the search for early hints that things in the Fed's thinking are starting to change, markets would be well served if they focused more on comments made by those three key Fed officials only and view the true significance of any comments made by other regional Fed Reserve Bank Presidents with extreme caution. In recent years, the latter have caused, all too often, a lot of commotion for their purported significance regarding Fed policy, while in the end they have turned out to mean not much at all. Regional Fed Presidents are independent thinkers and are obviously entitled to expressing their own views in their public appearances. But when the time for a vote at an FOMC meeting comes, there is usually only token dissent (1 or 2 votes), as they tend to fall in line with the majority represented by the Chairman, and always, the President of the New York Fed.

Anthony Karydakis