Can the split in the Fed survive?

Many Americans envision the Federal Reserve as a single entity with one authority at the helm.

When the Fed chair speaks, there’s usually a noticeable ripple effect in the markets, and interest rates react. It gives off the impression of a coherent structure—one leadership, one direction. However, the reality is more complex. Current political dynamics in Washington could shed light on the underlying tensions within the Fed, which have existed for nearly a century.

At its core, there’s an overlooked fact: while it may seem that everything is under control, the mechanisms of monetary policy are not as straightforward as one might assume. Legislators theoretically possess power over this area, but a surprising reality lies beneath: the tools of monetary policy aren’t managed by the same agencies that oversee the everyday operations.

Feeling a bit lost? You’re not alone.

Two chairs in the Fed.

According to the Federal Reserve Act, the President nominates the Chair of the Board, who is then confirmed by the Senate. This individual oversees the regulatory and supervisory aspects of the Fed and manages its interactions with Congress.

In contrast, the interest rate policy that markets closely monitor is governed by another body—the Federal Open Market Committee (FOMC). This committee directs open market operations and elects its own chair, leading to some confusion since both roles often share the same title.

Typically, the distinction between the Fed chair and the FOMC chair has been insignificant, as both roles generally align due to expected smooth confirmations. Historically, the FOMC has always selected an active chair of the Board for this position. But then again, politics can be tricky.

What if the Board chair position is empty?

As Senator Thom Tillis (R-NC) has suggested, he doesn’t support confirming a specific candidate, implying that this could lead to a stalled situation at the Fed, particularly with the ongoing inquiry into Chairman Jerome Powell. The investigation pertains to Powell’s testimony about renovations at the Fed’s headquarters. This concern raises fundamental questions about whether this stems from institutional defense or just political maneuvering. Either way, the implications are significant: the Senate’s confirmation process might come to a standstill.

Now, what happens if Powell’s term ends and there’s no successor? Statements from various senators hint at an evolving narrative around how the Fed operates. Although Powell would presumably remain as chairman until a new appointment is confirmed, the law actually contradicts this expectation. While Fed board members can stay seated until someone takes their place, once the chairman’s term is over, they leave the role.

If there’s a vacancy due to delayed confirmations, who takes over? According to the law, if the current chair is not available, the board can appoint a temporary chair. But this typically applies to short absences. In situations where there’s an outright vacancy, the law doesn’t provide clear guidance.

There have been instances of temporary vacancies in recent years, including during Powell’s tenure when his nomination for a second term was confirmed only after his first term ended. The board decided he would remain in an interim capacity. A similar scenario played out with Alan Greenspan. But back in Jimmy Carter’s presidency, he shifted away from reapplying Arthur Burns, appointing G. William Miller instead. Unfortunately, there was no time for Senate confirmation before Burns’ term expired. The Office of Legal Counsel determined that the president could appoint an interim chair from the existing board members, but not that the board could decide on its own chair.

Thus, if Tillis were to obstruct Trump’s nominee, Kevin Warsh, the president could select any sitting governor to chair the Board—likely one he nominated, such as Michelle Bowman or Christopher Waller.

Yet, it’s important to remember that the FOMC operates autonomously and elects its own chair. This committee comprises seven board members and five rotating local bank presidents. Hypothetically, a majority could elect a chair without regard to the White House and Senate. If Powell’s term on the Board expires while he remains on the FOMC, he would still be able to vote and even be considered for a leadership role, despite losing the chairmanship.

Which monetary policy tools truly count?

This aspect adds a layer of complexity, as the possibility for discord within the Fed increases.

The current interest rate framework revolves around the interest paid on reserve balances—what banks earn for maintaining reserves at the Fed. This isn’t trivial; it sets the foundation for how banks behave regarding lending. In a post-crisis environment, this interest rate effectively stabilizes the market, as banks won’t lend less than they could earn risk-free at the Fed. Thus, the primary tool for enforcing monetary policy has become this interest on reserves.

Unlike the more well-known federal funds target rate, the interest on reserves isn’t dictated by the FOMC but is managed by the Board. Under typical circumstances, the Board aligns the reserve ratios to correspond with the FOMC’s targets, creating a smooth process. But the legal separation still exists. Direction comes from the committee; the control over operational mechanics rests with the Board, which makes decisions by majority vote rather than by the chair’s authority.

If internal disagreements arise, the markets could experience real conflict. A dual authority system exists, with the FOMC chair managing the interest rate discussions while a majority of the Board controls the variables that establish short-term rates.

Historically, the Fed has presented a united front; divergence between the Board Chair and the FOMC Chair is a rare occurrence. Few would imagine a scenario where the FOMC sets one rate while the Board goes in a different direction regarding reserves.

The potential for disruption is something that wasn’t anticipated. Congress designed the Fed to distribute its authority, partly to prevent concentration of power among a few individuals. Under normal conditions, confirmations progress seamlessly and personalities align smoothly.

A Senate blockade disrupts this balance. Board members can stay until their successors are confirmed. A close margin could mean one individual’s vote becomes critical in determining the actual floor rates that govern the market. If Powell remains after his term expires, he could potentially retain voting rights on the FOMC and still influence the Committee, leading to a situation where the outgoing chair influences the federal funds rate while a new chair manages the agency and Board overseeing reserves.

Central banking hinges on trust as much as on statutory frameworks. The current hurdles in confirmation could put that very trust to the test.