President Barack Obama has nominated an exceptionally well-qualified economist as the next chairman of the Federal Reserve. By the way, once confirmed ― as few doubt she will be ― Janet Yellen will be the first woman to lead the central bank in its 100-year history.
The new chairman will have her work cut out. Five years after the financial crisis, the U.S. economy is frail, and its largest banks are still oversized and undercapitalized. Congress and the White House are so much at odds over fiscal policy that most of the federal government is shuttered, leaving only the Fed to provide the needed stimulus. It has already cut short-term interest rates to almost zero, and it has had to pursue other, more novel approaches to stimulate growth and put people back to work. It may have to do more, even as the dangers of further quantitative easing mount.
Deciding when and by how much to taper the Fed’s $85 billion of monthly bond buying is the most pressing question Yellen faces. This is both a substantive policy question and, remembering the importance of shaping market expectations, a communication problem. The Fed has to form the policy and tell markets about it well in advance. As the past few months have shown, it isn’t easy.
For one thing, the policy question is complicated. For another, not all Fed governors think alike ― and every statement each of them makes is meticulously examined for clues about what’s coming. Minutes of the Sept. 18 meeting show that several Fed governors considered improvements in the job market strong enough to justify a reduction in asset purchases right away. Luckily, with Yellen’s support, the outgoing chairman, Ben S. Bernanke, kept the program as is, contrary to expectations.
That was wise. Nonetheless, several times this year, the Fed created a muddle when it tried to lay out a tapering strategy and markets saw a signal that interest rates would rise sooner than expected. The central bank’s attempts to guide expectations at times have driven up yields, pushed down stock prices and tightened policy to an unintended degree. Yellen has been the governor leading the Fed’s communications subcommittee, and she deserves part of the blame.
As chairman, she can’t force Fed governors to agree, nor should she discourage opposing points of view. But she can use her chairman’s bully pulpit to press her views, especially when the data are on her side, as they most certainly are now.
With the economy still weak, inflation low and fiscal policy acting as a brake, continued monetary stimulus is needed. Inflation is running at around 1.2 percent annually and has been half a percentage point or more below the Fed’s 2 percent goal for almost a year. The August unemployment rate of 7.3 percent was well below the 5.2 percent to 5.8 percent level the Fed favors. And that 7.3 percent is flattering: It hides the fact that employment as a share of the population has hardly budged since the recession hit bottom, raising concerns that the eroding skills of the long-term unemployed will leave them permanently jobless.
Yellen may be a little less concerned than Bernanke has been about the risks of further unconventional stimulus. In fact, Bernanke’s misgivings are well founded. A bloated, $3.75 trillion balance sheet could cause financial instability by inflating asset bubbles or driving investors into high-yield instruments of poor quality. The size of the Fed’s holdings could also leave it exposed to losses when assets are sold. These dangers are real, but as Bernanke and Yellen have both reasoned, the risks of premature tapering ― a faltering economy and permanently elevated unemployment ― outweigh them for the moment.
Even if Yellen can mitigate the too-many-voices problem, the challenge of forward guidance will remain. How should the Fed frame its efforts to steer expectations? Yellen pushed the Fed to add numbers to its guidance ― to say that the fed funds rate wouldn’t increase while unemployment was higher than 6.5 percent and expected inflation less than 2.5 percent. But the Fed then had to explain that the unemployment number is a “threshold,” not a “trigger.” Depending on the circumstances, the Fed might keep interest rates at zero, even after unemployment has fallen to less than 6.5 percent.
This is complicated and confusing. It would be better to make a simpler promise, such as pledging to keep interest rates very low until the end of 2016, no matter what. Or to let actions speak louder than words by maintaining its present policy until further notice because of the still-weak economy. The current strategy on guidance is an awkward hybrid of those contrasting approaches, and it isn’t working.
The Yellen nomination is excellent news. It will be even better news if she promptly acknowledges the defects of the present approach to forward guidance and suggests a remedy.
