Is Jerome Powell's Renomination Now in Peril?

The deepening personal trading scandal among Federal Reserve officials could ultimately impair Chair Jerome Powell's shot at a second term. Could that spell the end of average inflation targeting before it even gets started?

Meanwhile, Friday will bring us the September employment report. With the Fed already intent on curtailing bond purchases, what impact will this jobs report have on markets?

Lastly, the yield curve has steepened steadily since the September FOMC meeting, but that's a trend that will soon reverse.

Here's my take on all three of these issues.

Powell in Peril

On Friday, Bloomberg News reported that Fed Vice Chair Richard Clarida sold bonds and bought stocks the day before the Fed announced they would "act as appropriate to support the economy" on Feb. 28, 2020. This revelation comes on the heels of resignations by two regional Fed Presidents over questionable personal trades.

The Clarida situation is complicated, and I'm not especially interested in debating the ethics of his trade. On one hand, Clarida would have knowledge that the Fed was actively considering liquidity measures, something that would constitute inside information at any Wall Street firm, including Clarida's former employer PIMCO. On the other hand, nothing was actually announced on Feb. 28, just a statement of support. Second, the market actually plunged over the next few weeks, so Clarida's timing wasn't great. Third, Clarida claims these trades were part of a pre-authorized rebalancing, which if that was actually authorized even a week prior to the execution, would change the narrative around these trades by quite a bit.

Regardless, we know that Chair Powell's renomination is a political event, and politics is all about optics. Within President Joe Biden's circles, the opposition to Powell is about him being too loose with banking regulations. The appearance of the Fed seeming to be too loose in governing personal trading plays right into this narrative (i.e., if this is how closely he's watching over his own inner circle, how closely can the Fed possibly be policing banks?).

Here's what investors should be watching on this story. Prior to now, the presumption was that if Biden went another direction, he'd pick long-time Fed Board member Lael Brainard. If that winds up happening, it probably isn't a big deal for markets. Brainard would undoubtedly execute the average inflation targeting (AIT) framework about the same as Powell would.

However, these personal trading issues could lead Biden to pick someone from outside the current Fed regime. One name that has cropped up over the weekend is former Fed Vice Chair Roger Ferguson, who recently retired as head of TIAA-CREF.

Anyone selected from the outside becomes a major wildcard. For example, the last time Ferguson sat in a FOMC meeting, the approach to tackling inflation was quite different. While Ferguson appears to be supportive of AIT in concept, how would he actually execute the framework? Just last month Ferguson said, speaking in a webinar, "While I am supportive of the new regime, one must recognize that it has both strengths and weaknesses... It seems to me that it is challenging to decide and communicate how much overshooting is allowable and for how long."

The current thinking is that Biden will make his decision on Powell this month, so how this personal trading narrative develops in the next couple weeks could matter quite a bit. I don't know the odds of an "outsider" getting the nod, but a week ago I would have said the odds of someone besides Powell or Brainard were infinitesimal. Now I no longer think so.

The tell will probably be if we start hearing names floating around financial media. Many of the important economists connected to the Obama/Biden team don't have especially high national profiles, so some vetting will be needed.

If we start seeing reports of new names being considered, I'd guess it is over for Powell.

Jobs Report Still Matters, but Not the Way It Used To

Getting back to the current Fed regime, the way we need to interpret the employment report has now changed significantly. The headline job gains figure is not as important as it once was. Right now there's not much debate that demand for labor is quite strong, so how many net hires actually occur is mostly a function of labor supply.

In theory, wage growth is extremely important, especially for Fed policy. Strong wage growth has two crucial impacts. On one hand, wages are basically a universal cost input, impacting all firms. On the other hand, higher wages give consumers additional income to spend. So higher wages simultaneously creates an impetus for firms to raise prices, and gives consumers the ability to pay higher prices. Wages are the critical component to inflation remaining above trend after all the pandemic-related inflationary effects have passed.

Unfortunately, the published Average Hourly Wages are being distorted by the highly variable industry mix of hires and layoffs. For example, in August, job growth disappointed overall, but that was almost entirely because restaurants and hotels stopped hiring completely. Because those jobs are lower paying compared to some other sectors, this made the measured change in wages appear to be relatively high at +0.6% for the month (over 7% annualized).

When it comes to wages, what we want to measure is the underlying wage pressure, which gets distorted by these industry mix problems. Either way, the wage situation is similar to the labor demand question referenced above. We can take it for granted that wage pressure is currently strong. Whether wage pressure remains strong is probably a function of labor supply.

On that front, the next two payroll reports are critical. During the first half of 2021, many blamed weak labor force participation on generous unemployment benefits. As of this payroll report, those have expired completely. But even before now, the extra benefits had expired in many states, and there wasn't much evidence that labor participation was meaningfully better in those states.

Another possible reason given for weak labor supply growth has been child care. Thus there's been some hope that participation will pick up when school starts. If that's going to happen, we'll see it in the next two monthly reports. If it doesn't happen, it tells us labor supply is bound to remain challenging for the longer-term, and the current strong wage pressure will remain with us for the rest of this recovery.

Anything That Pulls Forward Rate Hikes Will Also Flatten the Yield Curve

Since the September FOMC meeting, the yield curve has bear steepened, meaning all rates have risen, but longer-term rates have risen by more than shorter-term rates. This trend will be short-lived. As I wrote last week, the yield curve always flattens when the Fed is hiking. So if Friday's employment report seems to support a 2022 rate hike, fundamentally the curve should flatten. Moreover, if a change at the Fed's helm portends faster (or more) rate hikes, the curve should flatten.

Right now, a flattener trade doesn't have good technicals, and I think that's a function of people still rotating positioning for a higher rate environment. But before too long the core fundamentals will take over and the curve will be flattening.

At the time of publication, Graff was short 5-year, 10-year and Ultra 10-year Treasury Futures.