Biden should look to Britain and Europe for Federal Reserve reform

For Americans, their reaction to the stability at the top of their monetary policy regime may be a mix of relief and disappointment. Relief because Joe Biden has decided to nominate Federal Reserve chairman Jerome Powell for another term, thus avoiding another ugly fight in Congress with Republicans who would have been determined to retain Donald Trump’s appointee.

Disappointment because he had an opportunity to leave his mark by promoting Lael Brainard, a Fed governor of seven years’ standing and the favourite of the progressive wing of his Democrat party.

But for financial markets the overriding feeling is of a messy, unpredictable and highly politicised process.

In a typical piece of artful political compromise, Biden decided to keep markets calm by handing Powell an extra term, while tapping Brainard to become vice chair – a package likely to sail through both houses of Congress.

She will be in a strong position to guide Fed policy on three issues where Powell has been criticised for being laggardly in addressing: climate change, bank regulation, and a central bank digital currency.

Brainard has been a strong critics of deregulation of financial institutions, dissenting against the easing of rules covering banks’ capital buffers and liquidity provisions under the Trump administration.

She is also seen as someone who would focus on the impact of climate change on the stability of the financial system and to be more open to the Fed adopting a digital currency.

The one area where her appointment is less likely to be significant is on the direction of monetary policy. As Paul Donovan, chief economist at UBS Global Wealth management, has remarked, a lot of virtual ink has been wasted about what this signals for monetary policy. “It is hard to cast Fed chair Powell in the same position as previous Fed leaders,” he says. “Economic policy leadership was more influenced by people like Brainard.”

In fact, Biden still has plenty room to shape the Fed’s outlook on monetary policy as he can still appoint three governors. One is a vacant seat, the other is held by Trump appointee Richard Clarida whose term expires in January, and the role as vice chair for supervision, previously held by Randal Quarles who has resigned, will almost certainly go to Brainard.

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This will give him an opportunity to add a dovish tilt to the Federal Open Market Committee (FOMC) since he can pick nominees who will prioritise a broad and inclusive employment recovery. This will leave the Fed on track to push ahead with its plan to taper bond purchases and start raising interest rates sometime in 2022, perhaps as late as December.

But it shouldn’t be done this way. The “will he, won’t he” shenanigans over the appointment is a reminder that the selection of the head of the central bank is still an intensely political process even in advanced democracies.

This is because of an implicit tension with so-called independent central banks. The role is immensely powerful, yet is carried out by an unelected unofficial. To counteract that, politicians retain the power to pick the leaders and to cross-examine them on their performance.

Politicians often split the difference by agreeing to renew the terms of governors who are doing a good job, which is why Trump’s decision to replace the respected Janet Yellen with Powell was seen as a typically cynical overreach. Turkish president Recep Tayyip Erdogan’s demands for interest rates cuts in the face of soaring inflation is an extreme example.

The problem is that these roles come up for renewal too often. Powell will begin another four-year term next year and would technically be up for renewal in late 2025. Alan Greenspan was reappointed for five successive four-year terms.

There are signs of change on this side of the Atlantic. For the last 50-odd years the five-year term of each Bank of England governor was renewed once until Mark Carney’s first term was extended, initially by two years to oversee an orderly Brexit and then by another two months to ease the transition to Andrew Bailey in March 2020.

The UK Treasury decided to give Bailey an eight-year term, renewable once. Even better is the system in Frankfurt where the European Council gave Christine Lagarde an eight-year non-renewable term to run the ECB. Non-renewable terms eliminate pressure on the governor to please politicians.

That should be a model for the United States when Powell’s second term ends in 2026. As that would be halfway through the 2025 to 2029 presidency it would separate the monetary policy leadership cycle from that of the federal government.

Sadly, we get then get back to politics as the most polarised Congress in living memory would have to approve any change.