When Ben Bernanke completes his second term as Federal Reserve Board chairman in January, Janet Yellen should be more than ready to take the helm of the U.S. central bank, according to Wharton faculty and other experts. Current Federal Reserve Board vice chairwoman Yellen, appointed on October 9 by President Obama to succeed Bernanke, is widely respected as a first-rate academic economist with decades of real-world experience in monetary policy.
While serving as San Francisco Federal Reserve Bank president, the Yale-trained PhD economist sounded early warnings about housing market risks that soon proved correct when the 2008 financial crisis hit. A former Clinton administration Council of Economic Advisors chairwoman and University of California at Berkeley professor, Yellen, if confirmed, would become the first female Fed chief.
The Fed, which has changed its modus operandi dramatically since the financial crisis, is in great need of a steady hand to steer it through many unknowns, including any fallout from the unprecedented $85-billion-a-month asset purchases started under Bernanke, experts say. Indeed, under the watchful eyes of investors, Yellen “will have to navigate uncharted waters in the coming years,” says Wharton finance professor Joao F. Gomes.
Quantitative Easing: Beginning of the End
Unlike current Fed chief Ben Bernanke, who enjoyed a relatively quiet first year in office before the financial crisis let loose, Yellen is likely to experience trial by fire from the get-go. Looming on her agenda is the closely monitored decision on when to start winding down the Fed’s massive bond buying program, which was instigated by Bernanke after the 2008 financial crisis to stimulate the U.S. economy.
“Tapering will be the first thing [Yellen] will be judged on after she takes office.” –Joao F. Gomes
The Fed has already come under fire for sending confusing signals on the tapering of its so-called quantitative easing (QE) policy. In June, Bernanke said the taper could start when the unemployment rate hits 7%. In August, the unemployment rate dropped much faster than expected to 7.3%, and investors widely believed the central bank would start winding down QE in September. Yields on 10-year Treasury notes and mortgage rates rose in anticipation. But in September, the Fed punted the decision, unwilling to end the stimulus when Washington’s brinksmanship over the budget deficit and debt ceiling continued to feed economic uncertainty.
Now, “tapering will be the first thing [Yellen] will be judged on after she takes office,” says Gomes. “Unavoidably, the decision will affect the financial markets, depending on whether she handles it well or not. She will have to find a way to establish herself very quickly.” However, he adds, Yellen is unlikely to spring any surprises. Besides strongly supporting clear communications to the public, she “has definite views of what works and doesn’t work, and you’ll naturally have the sense she will lean one way or another on any particular decision,” Gomes notes.
Unemployment in the spotlight
How would Yellen approach her decision to start winding down QE? With a reputation as a monetary policy dove who is more accepting of low interest rates to stimulate employment and growth, will she take a go-slow approach on the taper? In her confirmation hearings, Yellen will have to assure senators that she serves both sides of the Fed’s dual mandate, conferred by Congress, to ensure price stability and maximum employment alike. “She has to thread the needle between the Democrats, who want assurances for further supports for the economy, and the Republicans, who are concerned that [continuing] QE forever will give rise to asset bubbles that will set up the next crisis,” says Phillip Swagel, a University of Maryland public policy professor and former assistant secretary of economic policy at the Treasury during the George W. Bush administration.
With unemployment continuing to dog the recovery, though, Yellen may be just what is required for the times, according to Wharton finance professor Krista Schwarz. While Bernanke spent most of his academic career studying lessons of the Great Depression and ended up presiding over one of the worst financial crises in decades, Yellen, an expert in labor markets, may be uniquely qualified to address the current labor market malaise, notes Schwarz. “Yellen’s research has focused on the cost of long-term unemployment and the danger of a high unemployment rate, making a problem that’s cyclical turn into one that’s structural.” Yellen has co-authored studies with her husband, Nobel Prize winner George Akerlof, on the role of monetary policy in stimulating employment growth.
Concern over the labor market is one reason why the Fed decided against the taper. The natural rate of unemployment, at which labor markets are tight enough for the Fed to raise interest rates, is particularly difficult to ascertain now, Swagel points out. “We don’t know to what extent people who left the labor market will return when the economy strengthens.”
Schwarz observes that even though the unemployment rate is dropping, the employment rate hasn’t changed much. That means the decline in unemployment is due to large numbers of workers dropping out of the labor force. In August, the labor participation rate, or the percentage of working-age people actually employed, was at 63%, the lowest level since 1978, according to the Bureau of Labor Statistics. “Is [that phenomenon] cyclical and therefore something monetary policy can address?” asks Schwarz. “Or is it structural — having to do with an aging population — and therefore not appropriate for monetary policy” to tackle?
“Yellen’s research has focused on the cost of long-term unemployment and the danger of a high unemployment rate, making a problem that’s cyclical turn into one that’s structural.” –Krista Schwarz
According to Schwarz, the Federal Open Markets Committee (FOMC), the Fed group that sets monetary policy, has generally viewed unemployment as structural and beyond the purview of monetary policy. Though Yellen has not expressed her views, she may be more inclined to believe that a cyclical element is at play and that accommodative monetary policy can have a positive impact.
Indeed, if growth and employment don’t pick up, we could be in QE for a lot longer than expected, says Kent Smetters, Wharton professor of business economics and public policy. “We could have a Japanese-style lost decade. The conditions are very similar: We have a bad banking sector and lots of government debt. But in many ways, we’re in a worse position, because Japan has a high household savings rate, and we have a low savings rate. Tapering could be pushed off for 10 years, starting from the beginning of the crisis.”
Dove Among Hawks
Yellen may need all her powers of persuasion to find agreement on the taper among the 12-member FOMC, composed of the seven Federal Reserve Board governors, the New York Federal Reserve Bank president and a rotating roster of four presidents from the 11 remaining regional Federal Reserve Banks. She faces the prospect of a fractured FOMC, at least early in her term, says Schwarz. Two of the regional Fed presidents rotating onto the 2014 FMOC — Dallas Fed president Richard Fisher and Philadelphia Fed president Charles Plosser — are inflation hawks, she notes. Though Yellen may have a hand in choosing the candidates to fill two current vacancies among the Federal Reserve Board of Governors, that process could take time, making “the two hawks a larger fraction of the committee.”
Gomes agrees that Yellen may well be questioned on her monetary policy views. “Is she able to bring the rest of the committee along with her? Will people at some point be [worried that] she’s less concerned about inflation than the Fed should be? That may become a more important issue two to three years into her term.”
Loretta J. Mester, a Wharton adjunct finance professor and director of research at the Federal Reserve Bank of Philadelphia, defends Yellen’s inflation-fighting attitude. Yellen “takes the dual mandate seriously,” she says. Swagel agrees: Yellen “might wait longer to tighten monetary policy, compared to someone else, but she will be within the mainstream.”
The Big Unknown
The prospective Fed chair’s biggest challenge is much larger than just the decision on when to end QE. The innovative bond and mortgage security purchases that Bernanke used to fight the financial crisis have now put the Fed’s portfolio at $3.7 trillion. These tools present an unprecedented change in the Fed’s operations, and the repercussions are unknown.
“Because we’re using tools we haven’t relied on before, it’s a different challenge now to know when [to change monetary policy],” says Mester. “We’re in a situation where the interest rate is at zero, and we’re using asset purchases and forward guidance on asset purchases as tools. There’s not much of a body of experience and research with which to understand the reaction function [the relationship between monetary policy changes and the economy]. Navigating in this uncertain environment poses challenges for any institution or chairperson.”
“No two crises are the same. I’m not sure anybody has a perfect skillset based purely on experience.” –Kent Smetters
Schwarz agrees. “Since the financial crisis, there have been many innovations to monetary policy implementation. These changes are the first significant changes in policy for quite some time.” Traditionally, she notes, “the FOMC sets the target [interest] rate; the market rate is what it is, and then the Fed withdraws or adds money to the system to [move] the market rate … to the target rate. That works when you have a balance sheet at the margin of being just large enough. In practice, market expectations moved the market rate toward the level of the target rate following FOMC announcements, prior to the actual adding/draining of funds [in] the system. Yet, the market rate was ultimately driven by banks’ management of funds – their desire to satisfy reserve requirements while keeping their unremunerated Fed account balances as low as possible.”
Now, says Schwarz, the Fed “has introduced interest on reserve balances, and that entirely changes how they achieve their target. Because they now pay interest on reserves, even though they have a large balance sheet, they can raise rates and get the rates in the market to rise as well.”
Crises in the Offing
The enormous injection of liquidity by the Fed also threatens another bubble. Both the Fed and the banks have trillions of dollars on their balance sheets as a result of the Fed’s asset purchase program, says Gomes. “The Fed will have to manage these amounts carefully to prevent an explosion of credit in the years ahead. The magnitude is so large — it’s never happened before — that it’s an act of faith that they have all the tools to prevent another boom and bust and inflation.”
Smetters concurs. “The Fed tripled money supply in the last four years, almost all held by banks in excess reserves. Even though we think subprime mortgages are behind us, they are not. The whole commercial side of the real estate bets will come to light next year, as the leases come up and we see the renewal rates and whether commercial loans are viable. There’s still a lot of uncertainty.” Moreover, there’s another great “crisis at our doorstep — the tidal wave of [public] debt,” Smetters adds. “How does the Fed keep the economy [running] when so many resources are going out to service higher debt and the budget deficit? Historically, the challenge has been met by printing money, which causes inflation. I give it a 95% chance that this crisis will come on Yellen’s watch.
If and when a crisis hits, will Yellen be up to the job? Like Bernanke, she is better known for her academic credentials, but as the former San Francisco Fed president and Fed vice chairman during and after the financial crisis, “she’s undoubtedly very qualified,” says Gomes. “Nobody was ready for 9/11 or [the stock market crash in] October 1987, and in the end, decisions were made by lots of talented people.”
“No two crises are the same,” Smetters adds. “I’m not sure anybody has a perfect skillset based purely on experience.”
Regardless of the events that might take place during Yellen’s tenure, it’s unlikely the Fed will revert to the days when it did its job in obscurity anytime soon. Already, “her nomination and confirmation are high-profile,” notes Schwarz. “I hope she will be slightly lower-profile than the past chair, but I’m not sure that’s possible now.”