In as much as anything in politics is a foregone conclusion, Janet Yellen’s confirmation by the U.S. Senate to be the next head of the U.S. Federal Reserve looks a certainty.
When she appears before the Senate’s Banking Committee on Nov. 14, it will be as the candidate of continuity. The head of the San Francisco Fed has also been vice-chair of the U.S. Fed since 2010 and a close supporter of outgoing chair Ben Bernanke and his ultra-easy monetary policy. She will be a consensual leader in the style of Bernanke, an underestimated quality at a time of complex decision making in often uncharted waters.
There is no doubting her credentials either as an economist or as a seasoned policymaker. She is, though, in the policy jargon, a dove. She was instrumental in formulating the Fed’s policy of holding interest rates near zero since late 2008 and quadrupling the central bank’s balance sheet to $3.8 trillion through three rounds of bond purchases, or quantitative easing. At the Fed’s October meeting, she was one of those voting to keep buying $85 billion-worth of bonds a month on the grounds that economic headwinds were still battering the U.S.’s recovery.
That will put her squarely in the sights of the Fed-critical Republican minority on the Senate Banking Committee. They say the Fed’s unorthodox and aggressive monetary policies have risked stoking financial instability and inflation. They will also sense red meat in her longstanding academic interest in the costs of long-term unemployment and her arguments that they might warrant allowing inflation to rise temporarily above the Fed’s 2% goal.
When it comes to shooting down her nomination, though, her critics will be firing blanks. Yellen should be assured of sufficient votes in the Democratic-majority Senate. If it comes to intellectual arm-wrestling over monetary policy and monetary policy tools, the smart money would be on Yellen.
Nor is she likely to say anything to rattle investors about when the Fed will start to taper its asset purchases or how long interest rates will stay low, a much as they will be straining on every word. She will, though, likely make a strong commitment to the Fed’s recent adoption of threshold-based forward guidance to encourage markets to keep long-term interest rates low. She was a leading proponent of this in the Bernanke Fed. In a happy coincidence of timing, the head of the Fed’s monetary policy affairs division, and colleagues have just published a paper underlining the efficacy of forward guidance.
That paper also says forward guidance would work even better if the current unemployment threshold was lowered to 5.5% from 6.5%. That would imply the Fed would give the unemployment rate more time to fall before raising interest rates. It would be surprising if Yellen let herself be dragged in to the weeds of that in her confirmation hearing. She will want to go no further than repeating the existing policy line that the Fed has no intention of tightening of monetary policy while the U.S. economy’s recovery remains fragile.
She will also likely be circumspect in her support for what is known as optimal control policies, even though some say adopting them could be the hallmark of the Yellen Fed as, as she has said, it would make the communication of forward guidance clearer. Optimal control policies are where a central bank sets itself macroeconomic targets — say a 6% unemployment rate and a 2% inflation over the long run — then models the optimal path of short-term interest rates to hit those targets. It then seeks to trim the federal funds rate to follow that course.
Modelling the numbers on such an approach suggests a Yellen Fed, should it follow it, would be more aggressive in fighting unemployment, implying lower short-term rates for longer, possibly into 2017. But as Yellen herself has noted:
While optimal control exercises can be informative, such analyses hinge on the selection of a specific macroeconomic model as well as a set of simplifying assumptions that may be quite unrealistic. I therefore consider it imprudent to place too much weight on the policy prescriptions obtained from these methods, so I simultaneously consider other approaches for gauging the appropriate stance of monetary policy.
Such caution is warranted. The Fed’s baseline projection is for the U.S. economy to be out of its sub-par performance and back to operating at something approaching full capacity by late 2016. Still guiding towards zero rates at that time would be fraught with danger. It would encourage excessive risk taking in the financial sector, bidding up asset prices and inflating another set of bubbles. Been there; done that; don’t want to go back.
Maintaining financial stability along with maximum employment and price stability makes monetary policy more complex and communicating it even more so. The Fed has been struggling with this ever since the 2008 financial crisis without explicitly saying so — a fact that goes some way toward explaining the difficulty it has had in communicating its intentions over monetary policy, and in particular the timing of the winding down of its massive asset-buying program.
Yellen certainly believes that financial soundness is essential for durable growth. “If confirmed by the Senate, I pledge to do my utmost to keep that trust and meet the great responsibilities that Congress has entrusted to the Federal Reserve — to promote maximum employment, stable prices, and a strong and stable financial system,” she said at the time her nomination was announced. Once that nomination is confirmed, how clearly she answers the question of when the Fed will normalize monetary policy by returning from asset purchases to interest rates will determine whether that pledge is met.