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ADV PART II
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Market Commentary

Report from Leen’s Lodge
August 2, 2013 David R. Kotok, Chairman and Chief Investment Officer

We are fifty people gathered here in the annual assemblage of opinion, incantation, invective, and argumentative dialogue. Put 50 economists and financial gurus in one place and you will certainly have 51 opinions. This year is no exception.

Much discussion and recurring debate is focused on the composition of the Fed (Federal Reserve) board after 2014. Take a look at the current members of the board. They can be viewed at http://www.federalreserve.gov/aboutthefed/default.htm.

Picture what this board may look like in one year. It is hard to believe that Ben Bernanke will remain a board member after being Chairman. We assume that the new Chairman will be in her or his seat by then. That may be Janet Yellen, Lawrence Summers, or someone from the second tier of considered names, such as Roger Ferguson, Tim Geithner, Christina Romer, or others.

The press attention and debate here seems to focus on Yellen and Summers. There are lots of views about the choice and the political machinations that would go into making it. Yellen is seen as a less political and more predictable person. Many here have met her both in official capacities and when she was a private citizen. She has a reputation for being gracious and tolerant, and she is well respected when it comes to her skills.

Summers is more controversial. Many here have met him in official capacities, in his university capacities at Harvard, and also in private sessions. For me personally, I have had the privilege to meet them both in their official capacities, and both are impressive. Summers in earlier times has been much less gracious and much more arrogant than Janet Yellen.

I can find no one who has a personality issue with Janet Yellen. There are a lot of people who have personality issues with Lawrence Summers.

Both have credentials in government and skills in economics. Summers is viewed as more political in his processes and methodologies. There is a clear and established personal political relationship with and loyalty to President Barack Obama. Janet Yellen does not have that insider political mechanism with President Obama. Her position on the Fed board and at the Federal Reserve Bank of San Francisco put her in a position where she needed to be less political and more independent in terms of view.

The debate here is centered on whether Summers has political baggage. He certainly does. Does his loyalty to Obama trump his political baggage? It may. Did his questionable comments, as President of Harvard, regarding female aptitude in math and science hurt him? They might have. Is the option of a appointing a woman of Janet Yellen's caliber as Fed Chair a factor that might weigh heavily in this selection by President Obama? It might.

Another speculative issue here is what happens if Summers becomes chair, is confirmed by the US Senate, and takes office as Fed Chairman in 2014. Does Yellen then leave the board? If she does, what does her absence do to alter the composition of the Fed board? Remember, she is currently the Vice Chair, serving an extended term. Will she stay if Summers is appointed Chair? All these are questions without answers.

Looking at the rest of the board, one can see the possibility of substantial change in the Fed board within one year, say, if Ben Bernanke is replaced by Lawrence Summers, Janet Yellen leaves because she was not selected, and Sarah Bloom Raskin moves to the Treasury. Elizabeth Duke has already indicated she is leaving, and Jerome Powell’s term ends in 2014. The Fed board’s current composition of seven experienced members could be reduced to Jeremy Stein, Daniel Tarullo, and five new people.

Market reactions were discussed here in depth. Of course, differing opinions abounded.

It seems as if a Janet Yellen appointment as Chair is the most predictable, trusted option and therefore entails the least risk premia expansion over Fed board composition. Yellen is a known quantity and her views are clear; she is articulate, with years of experience both in public office and in private capacities. She is familiar with the regulatory issues that confront the Fed.

Yellen is widely respected for her views. She is also viewed as one who is flexible. That means a resurgence of inflation when she is Fed Chair could bring about a policy change. While she may currently be characterized as a “dove” and has been a robust supporter of Bernanke’s policies, she is also a skilled and seasoned-enough central banker to know that a change in course will be necessary if inflation expectations demonstrably rise to the point where action is warranted.

Summers is less predictable. Therefore, the risk premia attached to his nomination are likely higher. How do we measure such things? Therein lies the great difficulty of trying to forecast. We gather here as 50 people with 51 opinions discuss how to measure risk premia over the choices in composition of the Fed board.

A lot of discussion has also focused on the structure of the Fed. Remember, the FOMC (Federal Open Market Commission) consists of 19 people. All 19 articulate their views at every meeting, but only 12 vote at one time, and thus only 12 votes determine the FOMC's policy decisions 8 times per year. Seven of the 12 voters are governors. We have discussed the possibilities of a massive change in the composition of that 7-member board.

The President of the Federal Reserve Bank of New York is also a voting member of the FOMC at all times. That is currently Bill Dudley, whose policy positions are consistent with Bernanke's and Yellen's. He is predictable in his views, how he articulates them, and where he stands on monetary policy. There is no reason to think Dudley would not continue his position at the Federal Reserve Bank of New York. There is no expectation that he will be leaving in the near future.

The other 11 regional bank presidents vote in a rotating system. At any given time, 4 of them are added to the Federal Reserve Bank of New York, along with the 7 governors, to make up 12. Some of those 11 have dissented from Bernanke's position and disagreed with the policy as being too soft or dovish. Others have dissented because they thought a policy decision did not reflect sufficient worry about deflation or disinflation. Hence they thought policy might actually be too tight.

There is discussion within the Fed. The presidents are articulate about their views, and they operate fairly transparently, or attempt to. Most of them are well-meaning, well-trained central bankers whose skills have been honed during the last five years in a remarkable financial crisis.

How many of those presidents will rotate in the next couple of years? We do not know. We can speculate by looking at their ages and their terms as presidents of their respective regional banks. There is no clear way to forecast which president would leave and when. The replacement mechanism in a regional bank is complex as well.

This means it is possible that the reserve of regional bank presidents, including Dudley, will be the historical memory at the FOMC within one year. It is quite possible that we might confront 4 or 5 new governors making decisions that are based upon their experience and knowledge, but not with the experience of surviving the financial crisis or implementing a new monetary policy. It would be an interesting switch to see the reserve bank presidents, seasoned as they have been by the fires of the financial crisis, acting as the historical memory of the FOMC, while the governors are mostly “newbies” when it comes to actual policy decision making under the fire of an emergency.

The final takeaway from the discussions at Leen’s Lodge is an analysis of market response. We are discussing and debating intensely how the market will react to possible combinations of new market governors and what those combinations might be. As I said, assemble 50 people, and you will get 51 opinions, robustly argued. Season spirited discussions with fresh fish, a glass of wine, and the pristine and invigorating August air in Maine, and our retreat becomes a remarkable gathering.

 

 

David R. Kotok, Chairman and Chief Investment Officer

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