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How will the election change the Fed?

(MoneyWatch) A lot of uncertainty surrounds the question of who will lead the Federal Reserve after current Chairman Ben Bernanke's term ends on Jan. 31, 2014. Although Bernanke is eligible to serve another four years, he has hinted that he may not seek another term. In addition, Republican presidential candidate Mitt Romney has made it clear that if he wins the election, he will appoint a new chairman whether or not Bernanke seeks another term.

If Bernanke is replaced, who is likely be the next Fed chief, and what impact will the change in leadership have on U.S. monetary policy?

If President Barack Obama is re-elected and chooses to replace Bernanke, I believe -- as do others -- that Fed Board of Governors Vice Chairman Janet Yellen is the most likely nominee. Her views are close to those of Bernanke, so she would provide the continuity that financial markets seek. She is also highly experienced, having served as president of the San Francisco Fed, and her academic credentials are very strong. She'll be able to handle the academic heavyweights on the bank's monetary policy committee. There are also political advantages for Obama if he appoints what would be the first female Fed chief.

If Romney is elected, it's a different story. Economists in the Romney camp, such as Stanford University's John Taylor, would be much more hawkish in trying to control inflation and much more devoted to following rule-based, rather than discretionary, policy.

Taylor, a favorite among many if Romney is elected, is responsible for the "Taylor Rule" as a guide to monetary policy. The Taylor rule links the interest rate set by the Fed to inflation and economic output so that interest rates rise when inflation goes up or the economy is booming, and fall when inflation is below target or the economy falls into a recession. He has been quite vocal in his opposition to any policy that deviates from this rule.

However, I don't think that Taylor is likely be the next Fed chair even if Romney wins, because the economist's hawkish views on monetary policy make him unlikely to survive Senate confirmation. I also don't think there's a strong favorite to point to if Taylor is out of the picture, though two other Romney economic advisers -- Columbia University's Glenn Hubbard and Greg Mankiw of Harvard University -- are often mentioned.


And in some ways, whomever is likely to get the nod in a Romney administration isn't that important, since that person is sure to have views that move policy in the direction that Taylor would favor.

But no matter who is in control of the Fed, in normal times policy is likely to be conducted much as the Taylor rule describes -- that was certainly true before the Great Recession. It's during abnormal times, as we've just experienced, when there is reason to abandon Taylor's approach and the differences in policy would emerge.

What would that mean for monetary policy? A Fed led by Taylor or someone with his views would be much less likely to react aggressively during a downturn or to implement bank bailouts, and much more likely to pursue a fast exit from any stimulative policies. For example, if Taylor had his way, the Fed already would have raised interest rates by now and would be backing off quantitative easing rather than implementing another round (if it ever pursued such a policy in the first place).

However, I don't want to overemphasize the differences even during unusual economic times. It's easy to criticize the Fed from the outside, and to proclaim that central bankers should stand up to the pressure not to bailout a troubled financial system. But when you are the Fed chair and it's your reputation on the line -- when people's livelihoods depend on your decisions, when the choice is between letting big banks fail and risking a complete blowout of the financial system -- or taking action known to stabilize the financial system, even hawkish chairs are likely to act.

After all, the bank bailout, though widely attributed to Obama, actually came under George W. Bush's presidency and was enacted with Republican support. If another financial meltdown happens, Fed action is likely no matter how much tough talk there's been in the past.

There's another reason to expect current policy to continue, at least initially, even if Fed leadership changes. The Fed chair, though very powerful, must still command a majority of votes on the bank's monetary policy committee in order to control policy. If the Fed chair proposes a radical departure from present policy, it is unlikely to be approved. Over time, as current Fed members' terms expire or they voluntarily step down, a president can shape the committee and policy through new appointment. But a new Fed chief would have a lot of trouble completely altering the course of policy on day one.

Of course, who wins the presidential election still matters. It shapes how aggressive and persistent monetary policy will be in combating unemployment, particularly during a severe recession. It also matters for another critical aspect of policy -- bank regulation. A Fed chair appointed by Obama would be much more likely to pursue strict regulation of banks than a Fed led by a Romney appointee. For those who believe that our current troubles are due, at least in part, to the failure to regulate the banking system, this is no small difference.

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