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Trading  | October 25, 2017

From the Macro View by Bloomberg macro commentator Ye Xie

Warsh, Not Taylor, Carries Most Risk for Stocks: Macro View

Kevin Warsh, and not John Taylor, is most likely to upset equity bulls, if appointed as the next Fed chair.

While now seen as a long shot, Warsh is the one candidate who seems to believe that policy makers should respond to financial cycles, instead of solely focusing on business cycles.

There’s an intellectual debate within the central bank community that could reshape policy making for years to come.

Mainstream inflation targeters, like Janet Yellen & Co. may be inclined to raise rates, but they’ll have to pause and reassess if consumer price growth remains subdued for longer than envisioned.

This group, which holds sway at all major central banks, pays attention to asset valuations but doesn’t see them as a primary factor in setting interest rates.

BIS economist Claudio Borio thinks differently. In a speech last month, he argued that central banks have little influence over consumer prices because of technology and globalization.

Low inflation, Borio argued, may be permanent and insensitive to policy rate changes. If central banks maintain low interest rates, they drive up asset prices and increase financial instability. Instead, policy makers should .tolerate low inflation and keep monetary policy tight to prevent asset bubbles

Central bankers in this camp are more asset-price dependent, rather than economic-data dependent. If the new Fed chair follows this thinking, the stock market will have a lot to worry about. So who is most likely to sympathize with this view?

The front runners — Taylor, Yellen and Jerome Powell — seem to be working with the traditional Phillips curve framework.

And the Taylor rule is based on the trade-off between inflation and the output gap. As my colleague Cameron Crise argued before, the Taylor-rule based policy rate may not be as high as commonly perceived, once you adjust the parameters.

Gary Cohn is a mystery, but he is generally viewed as a pragmatic rather than a disruptor.

That leaves Warsh, a frequent critic of post-crisis Fed policies. “Too many policymakers appear in thrall to financial markets,” he told the BIS annual meeting in 2016. “Reconsidering the transmission mechanism of financial markets and the responsibility of policymakers is of a piece with a reform agenda”.

At this point, Warsh is a long shot. But with Trump running the show, you never know. As long as he is in the race, he’s a sword of Damocles hanging over the heads of equity bulls.

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