US president Barack Obama is making final preparations to put forward Larry Summers to be the next head of the Federal Reserve, unnamed sources tell the Japanese newspaper Nikkei. An announcement could be expected as early as next week.
While some such as Sudeep Reddy at the Wall Street Journal have reminded us that Summers has been passed over before, financial markets have pretty clearly adjusted to increasing uncertainty about who will lead the Fed next. “Summers seems more likely than not,” wrote Deutsche Bank bond market analysts last week. “And there is some rationale for a Summers’ premium based on an end to guidance as we know it.”
What is a “Summers premium,” you ask?
One way the Fed has kept interest rates low is by using forward guidance. It has committed to keep interest rates low at least until US unemployment falls to 6.5%, so long as inflation doesn’t get out of control. But that’s been the mode of operation under Federal Reserve chair Ben Bernanke. There’s uncertainty about whether a Fed led by Summers—Bernanke is expected to finish at the Fed in January—would keep the promises of his predecessor.
Doubts that he would are reflected in the Fed Funds Futures market, where investors are pricing in hikes of the Fed’s key policy rate by next year, far earlier than that Fed’s official forecasts for unemployment (those suggest the fed funds rate won’t start moving until 2015).
This is important, because doubts about the Fed’s credibility can weaken the central bank’s influence over the markets. Indeed the continuity offered by Janet Yellen, a Fed vice chairman and key Bernanke lieutenant, was one reason she was once widely considered a leading candidate for Fed chair. If someone else takes over, the markets will need time to figure that person out. The Fed’s sway over the economy will weaken over that period, at least a bit. And US president Obama should keep that in mind.