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Easing into the Future: Federal Reserve Policy under Janet Yellen

By Emily Campagna

Macroshotbill

Note: “Easing into the Future” was written in November 2013, at the time of Janet Yellen’s nomination hearings. Since then, the Senate did confirm Yellen’s appointment as the Chairman of the Federal Reserve, and she assumed her new position on February 3, 2014.

It has been six years since the 2007/2008 financial collapse, and the United States continues to struggle through what has been labeled “the worst economic economic crisis since the Great Depression” (Council of Economic Advisers 3). From the start of the subprime mortgage crisis in December 2007 to the present, the U.S. Federal Reserve has been working to stabilize the American economy through monetary policy, with varying success. While the descent into a depression was halted, there has also been little movement upwards. Recovery seems to have flatlined, although the numbers do show improvement over the past couple of years. In the third quarter of 2013, for example, the annual growth rate of real GDP was at 2.8%, compared to 2.5% in the second quarter and 0.1% at the beginning of the year (Trading Economics). Still, the rate is low compared to the 4.2% annual growth in 2000 and a 66-year average of 3.2% (World Bank). Some economists worry, though, that the Fed’s current solution is too short-term. Its policies are ultimately unsustainable and may themselves become a threat to the economy. The leaders of the Fed must address that risk as they decide how to proceed.

Throughout the six years of crisis, Ben Bernanke has served as the Chairman of the Federal Reserve. He was a guiding force behind the recovery and the main developer of the Fed’s controversial stimulus strategy, quantitative easing (QE). However, his second and final term ends in January, making it necessary to appoint a successor. This person will be the one to define future Fed policy and the fate of the American economy. Will ordinary people be able to find jobs more easily, or will the cost of living rise with raised prices? Will the investors in the bond market lose their investments if the Fed stops buying long-term bonds in the process of discontinuing QE? Can there be a large enough economic comeback to bolster the dollar and restore the other nations’ faith and respect for the United States? These are the questions to which the next Chairman will determine the answers.

It was with these questions in mind that President Obama nominated Bernanke’s second-in-command, Janet Yellen, as the new Chairman. A sixty-seven-year-old Yale PhD with decades of both theoretical and practical knowledge, she certainly holds the necessary qualifications. After her nomination hearings in early November, the Senate is expected to confirm her appointment. Naturally, the finance world is keenly interested in predicting how she will handle the recovery. Already there are numerous articles about Janet Yellen and the ramifications of her nomination. Some are in her favor, others are not, but the truth of the matter is, the musings of newspaper columnists and experts at university think tanks cannot reverse the Senate’s decision. Yet, they can serve as a forecaster of things to come.

Like other articles on the topic, this paper seeks an answer the question, how will Janet Yellen shape the U.S. economic recovery? However, unlike the majority of similar articles, this paper will not try to predict Yellen’s effect on the economy. Rather, this paper will attempt to anticipate future monetary policy by first studying the person behind the policy, then analyzing past attempts at using such policies and examining the effects. One can thus deduce the future action of the Federal Reserve, the resulting direction the economy will take, and prepare oneself accordingly.

I. Yellen’s Track Record

Although not everyone agrees with Yellen’s economic philosophy, even critics admit that she is highly qualified for the appointment. She graduated from Brown University summa cum laude, then got a PhD from Yale under the direction of James Tobin, Nobel Prize-winning macroeconomist. She recently received an Honorary Doctorate from the London School of Economics. Her husband, George Akerlof, is another Nobel Prize winner with whom she has co-published peer-reviewed papers on the nature of labor markets. Over the course of her career, she has held multiple positions at universities as a professor and within the Federal Reserve, where, in fact, she met Akerlof. Under President Clinton she was Chair of the White House Council of Economic Advisers, and for the past three years, she served as the Vice Chair of the Federal Reserve. Between those two times, she was President and CEO of the Federal Reserve Bank of San Francisco. Clearly, though she has a history as an academic, her experience ranges well beyond the theoretical.

When it comes to economic philosophy, Yellen is a self-proclaimed Keynesian. She believes that capitalism is not self-correcting and not beneficial to everyone, and consequently, that laissez faire economics is destined to lead to some sort of financial ruin. She claims in her writing and speeches that the financial crisis was caused by too much freedom in the markets and not enough Fed or government regulation. The general solution, then, is increased regulation and Fed supervision. In her own words, “An inescapable conclusion is that a first-order priority must be to engineer a stronger, more robust system of financial regulation and supervision––one capable of identifying and managing excesses before they lead to crises” (Yellen “Macroprudential Supervision” 4). Yellen is also a proponent of using massive federal spending to stimulate the economy, as evidenced by her support for QE, a policy which she helped Bernanke craft. These modes of thought--the ideas that the free enterprise system is fundamentally unbalanced and should be regulated and that enormous government expenditure will encourage spending in the private sector--are two key elements of Keynesian thought.

Furthermore, as indicated by her past researching labor markets, Yellen’s passion is for employment, so it can be assumed that her priority will be lowering the unemployment rate. In economic jargon, this would make her a dove, as opposed to a hawk, who is focused on inflation rather than employment rates.

As a person, Yellen is known for her scholarship and for being very well-informed and well-prepared for public appearances. As a leader, though, she is more of a mystery. She has held management-level positions in the past, but she has never been so prominent in the public eye and every word she says can affect the markets. As reported in The Washington Post:

In interviews with more than a dozen people who have worked closely with Yellen, the portrait that emerges is of a careful and deliberate thinker who has been mostly right in her assessments over the tumultuous past six years of crisis, recession and grinding recovery. She has been a strong intellectual force within the Fed, a tough taskmaster for staff and single-minded in her desire to push down joblessness. She has been less inclined to wring her hands over the risks that the Fed’s easy money policies could create new bubbles or stoke inflation. If Obama appoints her to the top job, the open question is not what her approach will be to guiding the nation’s monetary policies; she has given detailed speeches explaining what she envisions for U.S. interest rate policies over the years ahead. Rather, it is how she would adapt to a role in which she is the person in charge. (Irwin and Mui)

So, although Yellen certainly has the academic background, she may be perilously inexperienced when it comes to being in the public spotlight. One can only expect, though, that considering her history of preparation, she will strive to overcome any personal challenges that arise.

II. Yellen’s Goals for the Fed

As mentioned before, Yellen is a dove, like her predecessor, Bernanke. She is focused on lowing unemployment rather than preventing inflation. Thus, she is expected to continue Bernanke’s dovish policies. She will try to keep interest rates low through more rounds of QE. She also plans to implement more Fed regulation and start monitoring the shadow banking sector, which played a significant role in the subprime mortgage crisis. However, she is primarily concerned with the private sector’s reluctance to take important risks, risks that will jumpstart production and consumer spending and help the economy revive. To eliminate this paralyzing caution, she will use a technique called “forward guidance” to influence market expectations, “promoting a return to prudent risk-taking” (Lenzer, Forbes). Basically, she will explicitly promise to keep short-term interest rates low for a longer period than normal, obliquely encouraging financial institutions to offer more loans. By providing both financial institutions and the private sector with more information about the Fed’s intentions, she gives producers and investors in the private sector an all-important confidence and feeling of security.

III. The Results of Yellen’s Policies

The current situation is as follows: “To restore the health of ailing financial markets and economies, central banks have driven short-term interest rates to essentially zero, expanded their balance sheets to unprecedented levels, and engaged in market interventions that have blurred the lines between monetary policy and fiscal policy” (Plosser 347). In short, quantitative easing. Yellen was instrumental in designing QE, so one can assume it represents her economic strategy.

At the most basic level, QE, also known as LSAP (Large Scale Asset Purchases) is a monetary policy by which the Fed seeks to increase the money supply in the private sector. By purchasing large numbers of securities, in this instance long-term bonds, the Fed sends capital to financial institutions, the money-lending sector of the economy. They in turn lend to the entrepreneurs who produce goods and the consumers who buy them, thereby promoting business growth and creating a cycle of production and consumption that stimulates the economy. As explained in “Expectations of Large-Scale Asset Purchases,” a paper generated by the Federal Reserve Bank of Kansas City:

In theory, asset purchases stimulate the economy by lowering interest rates at various time horizons. When the Federal Reserve purchases either Treasuries or agency MBS, which are securities that represent claims to the cash flow of sets of mortgages, this additional source of demand for these assets push up their price, hence lowering their yield. As a result, the interest rates associated with these assets fall. The decline in interest rates pushes investment from Treasuries or MBS into other sectors of the economy, which in turn stimulates economic activity and drives growth. Lower interest rates also make mortgages less expensive, fueling home purchases. (Foerster and Cao 6)

Currently, the Fed is spending $85 billion a month on ten-year Treasuries and mortgage-backed bonds (Lenzer, Forbes). As a consequence, the Fed’s balance sheet is now heavily weighted towards long-term bonds. Apart from the controversy surrounding the efficacy of QE, there are widespread concerns about its effects. It seems highly probable that there will be significant problems for the economy whether Yellen decides to continue the bond buying or begin tapering. She will have to choose between risking inflation and risking popping a Fed- created bubble in the bond market, which could potentially spark another crisis.

Continuing current policy could lead to inflation because, essentially, QE releases money into the economy, but without necessarily creating more goods to compensate for the sudden input. When there is an increase in money supply and no increase in goods, the purchasing value of money decreases – that is, a dollar is valued less than it was before. This phenomenon is inflation. It is most often reflected in raised prices for goods. Though continuing the QE money pumping could put the economy at risk for such inflation, Yellen has made it clear she intends to continue QE for the sake of boosting the employment rate. For her, inflation is not a pressing problem. She often cites the fact that, despite the several rounds of QE, inflation still stands at 2% (Lenzer).

Another effect of QE is that it creates a bubble market for particular assets by artificially raising their value. For instance, the Fed is dependably buying Treasuries and mortgage-backed bonds every month, forming demand. Because of the laws of supply and demand, those securities are then valued higher than they would with normal demand, encouraging investors to jump into a false market. The fear is that when the Fed announces it will start tapering off the bond buying, values will instantly fall and investors will flee the market in a mass selloff. Not only would it harm the investors who were unable to bail, but it might cause the Fed itself to sell its assets at a loss. In a worst case scenario, the Fed would sell so many assets at a loss that it would have an operating loss, meaning it could need a taxpayer-funded bailout.

However, the situation may not be so glum. Ramesh Ponnuro and David Beckworth, one a writer for National Review and the other a former international economist for the Treasury, argue that the pessimistic predictions of inflation and operating losses are unfounded. They write:

The claim that the Fed cannot be trusted to unwind its balance sheet--that it will let inflation go out of control--ignores its actual record over the last five years. Inflation has consistently come in below the Fed’s target and unemployment above it: The Fed has erred, that is, on the side of tightness. The last five years have seen a lower average inflation rate than any five-year stretch since the mid 1960s. (National Review)

Additionally, if the Fed chooses to “unwind its balance sheet,” rather than bringing spending to an abnormal low, it will actually bring spending down from an abnormal high. Lastly, Ponnoru and Beckworth point out that there is no evidence for a bubble in the bond market. There is no bubble psychology amongst investors; most of them mistrust the face value of the QE-boosted bonds, so they are avoiding the rash jump into the market that would boost prices higher still. Even if there were proof of bubble psychology at work, the Fed could always manipulate their market expectations to prevent the bubble from bursting.

There has long been a debate over the effects of government regulation on the free market. Supporters of regulation argue that it protects small businesses and individual consumers from monopolies and large, multinational corporations. The main criticism, though, is that by confusing business owners and making them uncertain of future policymaking, too much regulation actually prevents business growth. Because they are unsure of how they should proceed, they freeze, and rather than take the prudent risks that Yellen desires, put development on hold.

IV. The Chair’s Impact – It Matters

Some argue that, in the end, it does not matter who the Chairman of the Federal Reserve is, because the Chairman has little influence. If such is true, how can one make economic predictions based on Yellen’s personal opinion and economic philosophy? In the Forbes article “What Difference Does The New Fed Chairman Make? Less Than You Think,” Bill Conerly explains why he thinks Yellen’s appointment is unimportant: the most recent round of quantitative easing has been practically ineffectual, so tapering will have an equally small effect; the Fed’s regulatory power is reliant on the laws set by Congress; and the Chairman is just one of seven on the Board of Governors who vote on Fed regulation, and one of twelve who vote on monetary policy (Conerly, Forbes).

However, as discussed before, even if QE is failing to generate the desired results, it still impacts on the bond market. It is an effect so great that abruptly halting QE has the potential to cause a second financial crisis. Conerly does make a good point when he says that the Fed’s regulatory power is limited. Although the Fed was designed to be autonomous, it is really only independent of the federal government when enacting monetary policy. In matters of regulation, the Fed is subject to federal law. The leaders of the Fed, the Board of Governors, are all appointed by the President and approved by the Senate. Consequently, they rely on political support for reappointment. With such a structure, the Federal Reserve can never be truly separated from the government or from politics. Yet, because the Fed’s primary function is making monetary policy, its loose ties to the Capitol are not always a severe concern.

Also, although Yellen will have small voting power, her real strength will lie in her ability to influence market expectations. This is crucial to her plans to use forward guidance to encourage more risk-taking in the private sector. Within the Fed, the Chairman’s opinion is weighted very heavily. To the public, the Chairman is seen as the voice of the Fed. In fact, when Ben Bernanke once mentioned offhand the possibility of future QE tapering, he unintentionally prompted a large selloff in the bond market. No other member of the Fed’s Board of Governors has such credibility in the public’s eye. So, though the Fed may not have total control over QE’s effect and the regulations it can impose, and although the Chairman’s vote is but one of several, the choice of Chairman does matter.

V. Conclusion

With the hope of improving the unemployment rate, Janet Yellen plans to continue Bernanke’s policy of quantitative easing. She also intends to establish more regulations, especially in the area of big banking. Admitting that the Fed was caught off guard in 2007, she promises to monitor markets more closely in the future, especially the shadow banking sector. Finally, to spur more movement in the economy, she will use forward guidance to control market expectations, encouraging banks to lend more, businesses to produce more, and consumers to spend more. By enacting these policies, she runs the risk of inflation and too much restriction on capitalism.

It is difficult to judge whether Yellen will have a negative or positive impact on recovery. A researcher for the CATO Institute think tank writes:

The best exit would be for the government to adopt growth-oriented tax, spending, and regulatory policies in parallel with a new growth-oriented Fed resolve to downsize its role in capital allocation and commit to providing a strong and stable dollar. The combination would encourage investment and hiring in the U.S. private sector and would meet the Fed’s mandate of maximizing employment by assuring price stability.” (Malpass 375)

That situation would be ideal, but it would require such a superhuman degree of perfect timing and Federal Reserve-government coordination that even on the surface it sounds unfeasible. Yellen has been handed a delicate problem, and there are limited ways she can proceed. In the end, all that the bystander can do is be vigilant, try to anticipate what will happen, and position oneself accordingly.