It is hard to imagine a central bank leader having a more difficult time of things than Janet Yellen’s predecessor. Yet Yellen will confront a full slate of challenges when she succeeds Ben Bernanke as Federal Reserve chair in early 2014. Five years after the Lehman collapse she will confront an FOMC deeply divided over the direction in which the Fed should be moving.
Yellen must navigate her way through three difficult problems. First and most immediate is management of an underperforming American economy. While the Bernanke Fed shepherded the economy through recession and into recovery, it never quite managed to get America back to its full economic potential. Stubbornly high unemployment and dormant inflation point to weak demand as a significant problem, suggesting the Fed can and should do more to boost growth. The job is not easy. Economic headwinds, from government shutdowns to slowing growth across emerging markets, are in no short supply.
Meanwhile, there is little consensus within the Fed on how best to raise growth. Though some FOMC members support continued asset purchases — quantitative easing, or QE — others find QE’s risk-reward trade-off unappealing. Some FOMC members therefore advocate more use of communication to boost market expectations. Promises to leave interest rates low in the future, and even for a time after the economy heats up, should be stimulative. But while many economists reckon the Fed should promise to allow a little “catch-up inflation”, to make up for unexpectedly slow growth in wages and prices in recent years, tolerance on the FOMC for even a short period of moderate inflation is low. If markets think the Fed’s promise is a bluff then its communications policy will not work.
Yellen will need to act boldly. Delay is costly; the longer the unemployed remain out of work, the harder it will be for them to ever find new employment, and the lower America’s growth potential will be. And after a half decade falling short of its 2% inflation goal while missing badly on its “maximum employment” mandate, the Fed’s reputation for competent and capable economic management is in danger.
Secondly, Yellen must reassure markets that the Fed can manage its exit from extraordinary measures. Growth in the Fed’s balance sheet from years of QE has some on Wall Street nervous about the potential for runaway inflation. That is not a risk; by adjusting the interest rate it pays on excess reserves the Fed can very quickly discourage banks from lending against massive reserve hoards. Communicating this will be key to defusing political threats to the Fed’s independence. She may also need to finesse her way through a year or two of balance-sheet losses once interest rates begin rising. The Fed has been pouring balance-sheet profits into the Treasury in recent years, big enough to cover the modest losses that will probably occur when rising rates lead to lower values for the assets it holds. That almost certainly won’t stop Fed antagonists in Congress from using losses as a rhetorical weapon to attack “irresponsible” Fed policy.
More serious may be the regulatory challenges that fall to the Fed as economic growth accelerates. Bank leverage is well down from pre-crisis levels, profits and bonuses in the financial sector are looking relatively modest, and lending standards remain too tight in some important sectors. Stronger recovery may lead to post-crisis complacency, however; industry leaders are already insisting that post-crisis regulation went too far, and that Fed-initiated macroprudential policies should be scaled back. The Fed needs to demonstrate that it can remain vigilant during booms.
Third, Yellen must settle the debate over how the Fed’s monetary policy framework should evolve in response to crisis. Prior to the Great Recession monetary policy at the Fed, as at most other rich-world central banks, focused on low and stable inflation as the beginning and end of its macroeconomic management. Yet keeping inflation relatively stable at low rates did not prevent a major economic bust. Neither did it facilitate a rapid recovery. What’s more, years of low inflation helped reduce interest rates across the economy, including the Fed’s benchmark short-term interest rate: its main monetary-policy-making tool. As a result, the Fed had little room to cut the policy rate when crisis struck before lowering it all the way to zero. Once stuck at this “zero lower bound”, the Fed struggled to decide how to help boost growth. Recovery suffered as a result. Without some policy innovation the Fed’s role as economic stabiliser of first resort may steadily erode.
Luckily Mr Bernanke, with plenty of input from vice-chair Yellen, has put the FOMC on a path to a new policy framework that could help address all three challenges. The most important lesson of the crisis and its aftermath is that a pure inflation-targeting approach leaves an economy vulnerable to big swings in economic activity that the central bank can and should dampen. The interest-rate rule adopted by the Fed in December of 2012 — in which the Fed promises to keep rates low until unemployment falls to at least 6.5%, provided short-run inflation expectations are no more than 2.5% — is a step toward a more comprehensive framework. It acknowledges that inflation might be stable while demand is way too low, giving the Fed room to stimulate the economy even when inflation is not far from its target. But the FOMC under Yellen should go further, and adopt a framework that would apply after the crisis period has passed, and which would specify clearly the conditions when future FOMCs will loosen or tighten policy.
The most natural evolution is toward a nominal output target. Nominal output — or nominal GDP (NGDP) — is simply the dollar value of all the money spent or earned in an economy each year. NGDP is a broad measure of demand, and it rises with both inflation and real output of goods and services. Were the Fed to credibly target a path for stable growth in NGDP (in the same way it has credibly targeted low inflation over the past two decades), then firms and households would not have reason to fear that a shortfall in demand would cause a nasty recession. And in circumstances like the present, when demand (and NGDP) are way too low while inflation is only a bit too low, it would be clear that the Fed should act more aggressively. It would also be clear when the time has come to tighten policy: when NGDP is back to the desired trend level.
Selling the idea to a quarrelsome FOMC will not be easy. But a policy shift like this should have some appeal even to hawks at the Fed. Setting a clear, unambiguous new monetary policy target should make Fed efforts to raise growth expectations more powerful, and should therefore allow the Fed to rely less on QE. A new framework should improve credibility and reduce the perception that Fed policy is unmoored or ad hoc. And the new framework would allow hawks to point to a clear exit strategy: to say that this very simple metric, which balances our interest in stable prices and maximum employment, will determine when we pull back on QE and start raising interest rates. If Yellen can cement a broad consensus on what the Fed’s policy goal should be, she may find that the rest of her job has gotten much easier.
Author: Ryan Avent is economics correspondent for The Economist and the primary contributor to Free Exchange.
Image: U.S. President Barack Obama (C) announces his nomination of Janet Yellen (L) to head the Federal Reserve at the White House in Washington October 9, 2013. REUTERS/Jonathan Ernst