Dudley Do-Right? Or Very, Very Wrong?

By admin_45 in Blog Dudley Do-Right? Or Very, Very Wrong?

I have always thought of Bill Dudley as the classic “company man”. I saw him present when he was Goldman’s chief economist and later as NY Fed president. He was always the unflappable voice of reason. Whether he ended up being right or wrong, at least you could count on him to outline out a thoughtful (if usually consensus) argument.

He is, therefore the last establishment figure I would expect to go rogue, and yet with his now much-discussed Bloomberg piece published yesterday that’s exactly what he has done:

The title of his opinion piece: “The Fed Shouldn’t Enable Donald Trump” with the subtitle “The central bank should refuse to play along with an economic disaster in the making”.
The crux of his argument is that the current US-China trade war is a “manufactured disaster-in-the-making” that “presents the Federal Reserve with a dilemma: Should it mitigate the damage by providing offsetting stimulus, or refuse to play along?”
In Dudley’s opinion, “If the ultimate goal is a healthy economy, the Fed should seriously consider the latter approach”.
His reasoning is that a more accommodative Fed might “encourage(s) the president to escalate the trade war further, increasing the risk of recession”.
If Fed officials “state explicitly that the central bank won’t bail out an administration that keeps making bad choices on trade policy”, such a pronouncement could “benefit the Fed and the economy in 3 ways.”
“First, it would discourage further escalation of the trade war, by increasing the cost to the Trump administration.”
“Second, it would reassert Fed independence by distancing itself from the administration’s policies.”
“Third, it would conserve much-needed ammunition, allowing the Fed to avoid further interest rate cuts at a time when rates are already very low by historical standards.”

So far, this reads largely as a defense of Fed independence but Dudley’s close is what has people buzzing:

“There’s even an argument that the election itself falls within the Fed’s purview.”
“After all, Trump’s reelection arguably presents a threat to the US and global economy, to the Fed’s independence and its ability to achieve its employment and inflation objectives.”
“If the goal of monetary policy is to achieve the best long-term economic outcome, then Fed officials should consider how their decisions will effect the political outcome in 2020.”

Even if Dudley is now a private citizen, that a former senior Fed official would openly call for the central bank to work to unseat a freely elected president is remarkable. Bill Dudley never stood for popular election for his Fed post, and nor has any Fed official past or present. The Federal Reserve’s 1977 mandate from Congress is to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates”. This seems far indeed from “seek to damage an elected president because you disagree with his economic policies.”

Now, the most commonly espoused explanation for Dudley’s rabble-rousing is that his political tilt is more left than right. And if that’s as far as it goes, fair enough. Opinions are like belly buttons – everybody has one – and we all get to express them freely.

But back to our first observation: Dudley has no history as a crank and sports a resume that says he talks to the right people. About his worst flub until now was being tone-deaf at an outreach meeting in Queens NY when he was NY Fed president. When Dudley tried to explain away food and gas inflation by saying iPads were getting more powerful for the same money, someone in the audience called out “I can’t eat an iPad!” You can always count on Queens to keep it real…

So let’s assume Bill Dudley knew exactly what he was doing by publishing such an inflammatory piece and ask, “why would he do that?” It can’t be because he wants to be Fed Chair under a Democratic president… By openly calling for the US central bank to work against the actions of an elected leader, he just torched his chances for that. So what’s up?

Four possibilities, which are not mutually exclusive:

#1: He sees a new era where the Federal Reserve will no longer be able to claim political independence. In fact Dudley says, “Trump’s ongoing attacks on Powell and the institution have made that untenable”. But as America’s political discourse between left and right continues to sharpen, and with economic policy a major point of contention, the Fed may well be stuck in the middle whether it wants to be there or not.

Importantly, while Dudley’s commentary may be about current trade policy, it could just as easily apply to future issues like tax rates, universal basic income, and budget deficits. The Fed still has the biggest balance sheet in town and it may well be called on to use it to support government initiatives, especially during a recession. Will it do so to support UBI or other fresh social spending? Dudley’s paradigm of a politically active Fed makes that an open question.

#2: Dudley may have unique information about how US-China trade talks are likely to progress. Let’s assume a 20-year Goldman veteran who later sat on the board of the Bank for International Settlements (2008 – 2018) and held the second most important post at the Fed knows more than most people about what’s happening behind the scenes. If he sees the US position as untenable, he would naturally call for the Fed to distance itself from it.

#3) He knows the Federal Reserve will not follow his advice, but by painting a picture of a politically motivated Fed he gives Chair Powell and the FOMC some political air cover if/when the US economy does slip into recession. We have no doubt the Fed will cut rates in coming months, attempting to offset the effects of the ongoing US-China trade war. Dudley’s bizarre-world Fed wouldn’t do that… So while future rate cuts will not likely be enough to appease President Trump, Chair Powell can still claim political independence relative to Dudley’s proposal.

#4) The recession probabilities model from the New York Fed – Dudley’s alma mater – likely weighed heavily on his thinking as he wrote his opinion piece.

Its last reading (July 2019) was 31.5%, well into the territory that predicts a downturn in the next 12 months. The only input to this model is the difference between 3-month and 10-year Treasuries then was 0.08 (still positive, but barely so for a monthly average).
The August reading will be far worse, since 10-year Treasuries have averaged a yield of 1.75% this month but 3-months have hovered closer to 2.0%. The yield curve is now seriously inverted.
The bottom line: recession odds are set to hit new post-Financial Crisis highs when the next data comes out in September. We wouldn’t be surprised to see them at 40%.

Our bottom line to all this: establishment individuals don’t go off the reservation without a very good reason. Bill Dudley is smart enough to know his piece would draw a response, and he still wrote it. If his motivation went beyond simple politics – and his background says that is the case – then its message is important.