In mid-May, Janet Yellen will complete her first 100 days as chair of the Board of Governors of the Federal Reserve System. After taking the helm of the Fed on February 3 — with her official swearing-in a month later — Yellen has navigated an almost seamless entry into the new job, continuing both the style and substance of her predecessor Ben Bernanke, say Wharton professors. The only blip: a remark at her first press conference about when the Fed might start raising rates, which sent markets spiraling.
Yet, a relatively smooth start is no guarantee of calm waters ahead. Bernanke, for instance, enjoyed a quiet first year only to be hit by the biggest financial crisis since the Great Depression. Longer-term challenges may lie in wait for Yellen, too. Even as she and her colleagues tend to their immediate task at hand — carefully calibrating the Fed’s response to the slow economic recovery — larger questions loom.
For one, the relatively fast-growing economy prior to the 2008-2009 financial crisis may give way to a decade or more of slow growth, low productivity gains and slackening job creation, says Joao F. Gomes, a Wharton finance professor. “If that is the world we will live in [going forward], monetary policy may have to look different” and undergo a fundamental rethinking, he notes. The Fed chair must also keep an eye on other major long-term challenges, such as the potentially catastrophic impact of the federal budget deficit on inflation, adds Kent Smetters, a Wharton professor of business economics and public policy.
Imprint on Fed Guidance
For now, Yellen is focused on guiding the Fed’s exit strategy from its accommodative, post-crisis stance. Shouldering Bernanke’s biggest to-dos in his last months as chair, Yellen is continuing to manage both the taper of the Fed’s crisis-era asset purchases and the hotly anticipated uptick in the Fed’s federal funds rate, which has been at zero to 0.25% for the last six years. “The underlying message has not changed” from the tone set by Bernanke’s administration, says Wharton finance professor Krista Schwarz.
“Consciously or not, the dual mandate will be interpreted in the coming years to mean more of a focus on full employment and less on inflation.” –Joao F. Gomes
However, Yellen, a labor market expert, is starting to put her own imprint on the Fed’s guidance, backing away from Bernanke’s numerical unemployment-rate trigger for raising rates in favor of a broader array of labor market and other measures to assess how close the economy is to maximum employment and inflation targets. “She didn’t want to be pinned down by [the unemployment rate], especially given the statements she’s made about how the unemployment rate itself doesn’t necessarily reflect the state of the labor market,” notes Schwarz. “The goal was to loosen the constraints and to leave some scope to change [policy] as the economy evolves in twists and turns.”
By giving the Fed a little wiggle room, Yellen may avoid some of the communications miscues of her predecessor. Near the end of his tenure, Bernanke attempted to give the markets some guidance on when the taper of the Fed’s $85 billion-a-month Treasury and mortgage-backed securities purchases would begin, saying a year ago that the process would start when the unemployment rate fell to 7%, most likely in late 2013. The announcement unsettled the markets: Over the summer, stocks fell, and bonds rose in response. When the unemployment rate reached 7% in November 2013, the Fed waited and did not start the taper until January this year. Bernanke’s Fed then said it would keep short-term interest rates low until unemployment falls to 6.5% and inflation hits 2.5%.
By the time of Yellen’s first Federal Open Market Committee (FOMC) meeting on March 18-19, the unemployment rate had reached 6.7% (and has since fallen to 6.3% in April). At the end of the meeting, the committee continued the Fed’s taper, cutting its securities purchases to $55 billion a month, but jettisoning the 6.5% unemployment rate target by which the Fed would consider raising the federal funds rate. Instead, the committee adopted more qualitative measures, saying it would consider progress toward its twin objectives of “maximum employment and 2% inflation” before raising rates, taking into account “a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” The FOMC also said it would likely maintain a zero to 0.25% federal funds rate “for a considerable time” after the asset purchase program ends, especially if projected inflation is less than 2%.
Indeed, at her first press conference after the FOMC meeting, Yellen explicitly stated that the Fed would look at a dashboard of indicators to assess the labor market, not just the unemployment rate. Schwarz cites some of those indicators: “Since 2009, the [overall] labor participation rate, for example, has fallen almost exclusively because the labor participation rate of working-age Americans between 25 and 55 has dropped dramatically. In Yellen’s view, things haven’t improved as much as the headline numbers show. Employment rates have barely budged.” The U.S. labor participation rate is now 63%, the lowest since 1978, when women had not yet entered the workforce in large numbers.
“In Yellen’s view, things haven’t improved as much as the headline numbers show. Employment rates have barely budged.” – Krista Schwarz
Yellen also discussed assessing unemployment with a broader measure that includes those working part-time who would prefer to be working full-time and others who are not employed to the extent they would like, Schwarz adds. “Given these other measures, the job market appears worse than the 6.7% unemployment rate would suggest,” she says.
The wild card is still the question of when the Fed will judge the economy to have gained enough steam to raise interest rates. The March FOMC statement said the Fed would not raise rates for a “considerable time” after the body finishes unwinding its asset purchases. Yellen then inadvertently sparked a significant stock market sell-off when she defined that time period to a reporter, answering that it would happen in “probably about six months” — earlier than investors had expected.
Such a communications mishap is almost a rite of passage in the post-Greenspan era of more transparent communications from the Fed chair. A few months into Bernanke’s tenure, a remark to then-CNBC anchor Maria Bartiromo led to a similar market reaction. “Yellen is going to have to work herself through [communications challenges] just like Bernanke did over the last few years,” says Gomes.
For now, Yellen has been fortunate to avoid the tension that the Fed usually faces in fulfilling its dual mandate to promote full employment while fighting inflation. With inflation still in check, Yellen can afford to keep interest rates low while waiting for the labor market to firm up, some analysts say. “People keep thinking the normalization of Fed policy is right around the corner,” Schwarz states. “So far, this big inflation around the corner has turned out to be … non-existent. My own view is that the timing of tightening is further off than the central expectation of mid-2015 and may be in 2016.”
Others are concerned that the leeway Yellen is giving to the labor market may lead to more asset bubbles. “Consciously or not, the dual mandate will be interpreted in the coming years to mean more of a focus on full employment and less on inflation,” says Gomes. “And the tension between protecting against the threat of new asset bubbles and ensuring the economy finally reaches escape velocity will only become more pronounced.”
“The biggest threat of inflation over time is the fact that the White House and Congress can’t balance the budget.” –Kent Smetters
Gomes hopes that Yellen’s sensitivity to labor markets will not dominate Fed policy. “I am skeptical that labor markets should be the main priority of a central banker,” he notes. “When you run monetary policy, you’re a little too far away from the labor markets to be able to influence what is happening. I worry a little bit that she will lose sight of other parts of the economy where she could have impact and that are at least as important, such as supervision and regulation of the financial sector. Monetary policy is essentially about the financial sector, and that is something we should not forget.”
Longer term, adds Gomes, “the biggest [question] is: ‘What is the new normal?’ We were used to a world economy growing at about 3% a year for 15 years, expanding quickly and creating lots of jobs. Can the economy still do this with expected demographic changes, the aftershocks of the recession and new sectors dominating it?”
If growth and job creation slow down over the next 10 years, as suggested by Congressional Budget Office (CBO) projections, the Fed may have to tighten a little earlier, Gomes says. “If productivity does not rise as much as before, we will have inflation sooner,” he explains. “When you start to accept that you’re not going to create so many jobs, and labor participation is [stalled], instead of waiting for labor participation to hit 65% before you raise interest rates, you need to raise interest rates sooner. If future growth is about 2%, as the CBO projects, you need to raise rates sooner than if you think we will grow at 3% again.”
The Fed must also keep in mind another long-term threat to the management of the economy, says Smetters. “Though the Fed chair is primarily [concerned] about monetary policy, [he or she] should give constant reminders of the importance of getting the national debt under control,” Smetters notes. “The biggest threat of inflation over time is the fact that the White House and Congress can’t balance the budget. In the end, the Federal Reserve is going to have to pump up the money supply to deflate the value of all the debt we’re accumulating over next 20 to 30 years, and that could create a negative wealth effect. It’s one of the biggest issues the Federal Reserve faces. We’re on a train and going off a cliff in maybe 20 miles, but we’re still complaining how bumpy ride is now.”
A mere 100 days into her tenure, Yellen has time yet to tackle these issues. At the moment, says Smetters: “Markets have been happy with her forward-looking view, keeping the money supply easy and interest rates low for a while.”