Whither goeth the Federal Reserve? Yellen confirmed as Fed Chair

First, congratulations to Janet Yellen for becoming the first woman chair of the Federal Reserve system. Now comes the hard part…

Yellen has spoken out that she will favor full employment policies along with the low inflation agenda that the Fed has followed since the 70’s. I wholeheartedly endorse such a move, but the main question is what happens when those two agendas come into conflict? And I believe they will, if she is successful in implementing them.

So a series of questions for debate:

  1. How do you think she will be as Chair?
  2. How much will she be able to implement policies to achieve full employment? (For the sake of argument, define it as getting unemployment down to >5% with the majority being frictional, and not structural.)
  3. What policies do you expect to see?
  4. When full employment threatens to lead to higher inflation, what level would be acceptable?
  5. How much will her appointment affect the market and the greater economy?

My preliminary opinions:

  1. She has the academic skills and expertise to be as good as any previous Chair, but I know nothing of her political abilities other than achieving the nomination after Summers had to withdraw (so grateful for that!), and I think that reflects more on Obama and others than on herself.
  2. I think she will have a difficult time at first getting the rest of the Fed Reserve Board to agree, but I think they see the wind changing. Inflation has not been a real issue for most Americans compared to the effects of unemployment and underemployment.
  3. In regards to full employment, I think the Fed has limited ability compared to other agencies. Increasing business startups or expanding existing businesses falls more to the SBA and other Commerce programs. I am still looking at policy specifics, and looking forward to what others have to say. Structural unemployment is the larger reason, and the Fed is limited to what they can do there. That depends on worker retraining programs and educational policies.
  4. Inflation has mostly been tamed, but the pressure is still there. The main drivers have been energy and food, the least elastic commodities that people buy. Other goods have gotten extremely cheap with major increases in added value. The average PC, TV, or car are not comparable to those twenty years ago, and pure science fiction to what existed in 1980 when we needed to stop inflation at any cost. But that cost has been paid. I think we could tolerate 3 to 4% nominal inflation as long as real growth is higher. 0-1% inflation with 2-3% growth is great for the millionaires and above, but insufficient for those at the bottom.
  5. I think the market knew this was coming since she was nominated. Any changes will be gradual rather than drastic. Some corporate CEOs and hedge fund managers may complain about the shift in policy, but most state and local governments will welcome it. California would definitely love to pay less unemployment benefits because people are working, not because the benefits were cut.

So that should be enough to start.

  1. She will be somewhat more dovish than Bernanke under conditions likely to prevail in 2014, i.e. a weak economy with GDP well below its potential. The market will receive a surprise along those lines within the next 4 months, but not a major surprise. Maybe she will stop paying interest on excess reserves, maybe she will adjust forward guidance.

  2. She has been on the Board of Governors since the 1990s: I suspect she has mastered the internal politics of the place. Part of that mastery implies that she won’t get to far ahead of the consensus. Not that she’s a firebrand: I’m claiming differences of degree.

  3. Fiscal policy has tightened over the past 2 years: I expect such damaging policies to cease. Combined with still loose monetary policy could give us growth of 3%. Unfortunately, that’s not enough to create a hiring spree.

The essential problem we face is inadequate demand, not structural unemployment. Though there is more of that now than there was in 2007, thanks to contractionary fiscal policy. The stimulus package was followed by retrenchment, mostly via state and local cuts. For an interesting employment chart: check out the first one here: http://www.crgraphs.com/ Or this link: http://www.calculatedriskblog.com/2013/04/march-employment-report-88000-jobs-76.html

I would say that the Fed is currently pushing on a string but 2013 taught us otherwise.* We indeed faced a soft lower bound as short term interest rates were as low as they could go. But we did not face a hard lower bound, as long term interest rates could be pressed lower. Plus, when the Fed announced it might taper QE3, the markets drove up interest rates, surprisingly. So it seems monetary policy has at least a little life in it. Whether the real economy will react a lot to modest changes in long term rates is another matter.

  1. Inflation of the late 1980s era shouldn’t freak out anyone. The ideal inflation rate is probably closer to 4% than to 1.5%. With a background inflation rate of, say, 3%, cutting the fed funds rate to 0.25% becomes much more powerful. It also aids labor market adjustments, since employers tend to shy away from nominal wage cuts.

  2. Yellen might very well get credit for a surprisingly strong economy. After all, people aren’t going credit those in the legislative and executive branches who successfully fought off damaging budget cuts. That would be taking sides.

  • For those who like thinking about macro, this link is highly recommended.

Yellin will follow the exact same policies as Bernanke. The primary policy is to keep banksters rich.

I agree with the above about what Yellin will do. By all accounts, she was a big backer of Bernanke’s policies, and there probably won’t be much change.

She was clearly the best choice.

Some of your questions relate to her expected policies in the next year or so, and the effects on the market, but those questions are already answered. Everyone already knows what she’s going to do over the next year or two. The market effect has already been seen. She’s going to continue Bernanke’s policies, furthering the taper of QE3 and providing the macroeconomic criteria that would lead interest rates to rise. This is “forward guidance” of Fed actions, determined by conditions in the economy.

The more important question is longer term: how she will respond to another recession. If interest rates rise, they will rise slowly. When another recession hits, we should expect to hit 0% interest again.

So the big question of Yellen as chair is how much she will develop and refine the Fed tools, most especially forms of forward guidance and perhaps even a change in their policy goal or how they announce their goals. Part of the talk in money circles is nominal GDP targeting. Rather than setting a specific goal for inflation, they can instead aim for a certain amount of spending in the economy every year. That’s better for all kinds of reasons. Another possibility is to target their own internal forecast to ensure sufficient action rather than continually undershooting their own targets. Another technique would be level targeting instead of rate targeting, again to compensate for past mistakes.

These are stronger changes, and there’s not much clue whether she’ll pursue them, or how strongly. We’re definitely not going to see them soon. Maybe later in her tenure we’ll have a better idea of how nimble she is when faced with the loss of the conventional tools.

His explanation of “market monetarism” is a complete misrepresentation. It’s not even close.

I don’t see why he’s still getting this wrong. It’s been years, literally years, and he can’t even manage the most basic summary.