Investment Research 22 August 2013 Yellen vs Summers Bird fight
Fed chairman Ben Bernanke’s second four-year term expires on 31 January 2013 and his successor needs to be vetted by Congress before then. Although a dark horse cannot be ruled out, there are two clear candidates: Lawrence Summers and Janet Yellen. The debate of who is the most suited successor to Big Ben has been surprisingly little about the candidate’s economic views and the level of innuendo has been a US presidential campaign worthy. The US economy is on the path to recovery and it is now as important as ever how the new chairman plans to run future US monetary policy. This paper discusses the differences in economic policy of Yellen and Summers and in particular if it is fair to call Yellen the most dovish of the two.
Our conclusions are as follows. We believe that the characterisation by the media of Lawrence Summers as being more hawkish than Janet Yellen is too simplistic. In fact we argue that Summers and Yellen are equally dovish when economic conditions improve, since they both have a very strong aversion to unemployment relative to inflation. It is first when the US is hit by a negative demand shock while interest rates are at the zero lower bound that Summers is likely to be more hawkish than Yellen. This is due to Summers’s open scepticism towards alternative monetary stimulus instruments such as QE – a scepticism not shared by Yellen.
We point out the importance of a transparent Fed and we believe that Yellen would support this transparency. On the other hand, Summers’s flamboyant personality together with his comments that he will be a fire-fighting Fed chairman indicate that the Fed would become less transparent if he was to be chosen by Obama.
Both want to fight high unemployment Inflation remains low
Chief Analyst Lars Christensen +45 4512 8530 [email protected] Source: Macrobond, Danske Bank Markets Source: Macrobond, Danske Bank Markets Senior Analyst Signe Roed-Frederiksen +45 4512 8229 [email protected]
Assistant Analyst Kristoffer Kjær Lomholt [email protected]
Assistant Analyst Mikael Olai Milhøj [email protected]
Important disclosures and certifications are contained from page 7 of this report.
www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
Janet Yellen – The Fed dove with the steady hand
Janet Yellen - Résumé
Name and birth Janet Yellen, born 13 August1946 – age 67 Education PhD in economics from Yale University (1971) Graduated summa cum laude in economics from Brown University (1967) Working experience Chairwoman, President’s Council of Economic Advisors (1997-1999) Professor, UC Berkeley (1985-present) Associate Professor, UC Berkeley (1982-1985) Assistant Professor, UC Berkeley (1980-1982) Lecturer, LSE (1978-1980) Economist, Federal Reserve System (1977-1978) Assistant Professor, Harvard University (1971-1976) Fed experience Vice-chair of the Federal Reserve System (2010-2014) Member of the Federal Reserve Board (2010-2024) President of Federal Reserve Bank of San Francisco (2004-2010) Member of the Federal Open Market Committee, voting member (2009) Member of the Federal Reserve Board (1994-1997)
Political party Democrat Economic thinking Keynesian Dovish Personal traits Firm, disciplined and possibly less consensus-oriented than Bernanke
Janet Yellen is an American economist who was born in Brooklyn, New York. She graduated summa cum laude in economics from Brown University in 1967 and received a PhD in economics from Yale University in 1971. She is married to George Akerlof, who won the 2001 Nobel Prize in economics.
Yellen has a long history of economics teaching and research. She has taught at Harvard University, the London School of Economics and University of California, Berkeley’s Haas School of Business – the latter at which she has been a Professor since 1985.
Apart from serving as chairwoman of President Bill Clinton’s Council of Economic Advisors (1997-1999), Yellen’s career is characterised by a long history in the Federal Reserve System. From 1977-1978 she worked as an economist in the Division of International Finance, from 1994-1997 she was a member of the Board of Governors, from 2004-2010 she was the President of the Federal Reserve Bank of San Francisco, she was a voting member of the FOMC in 2009 and in 2010 she was not only appointed Daniel Kohn’s successor as vice-chair of the Federal Reserve System but also became a member of the Federal Reserve Board for a 14-year period (2010-2024).
Her biggest advantages in her Fed chairwoman candidacy are her many years of experience within the Fed system and her huge knowledge of monetary policy theory. Also her policy is unlikely to differ much from Bernanke’s and she is considered Obama’s safe choice. During her time as vice-chair in the Fed she has been head of a communication subcommittee. She believes agents’ expectation formation is key for economic activity and she would likely support Fed transparency as chairwoman - a key feature in relation to FOMC tapering.
2 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
Lawrence Summers - The shrewd and unpopular power player
Lawrence Summers - Résumé
Name and birth Lawrence Summers, born November 30 1954 – age 58 Education PhD in economics from Harvard University (1982) BSc. in Economics from Massachusetts Institute of Technology (1975) Working experience Director of the National Economic Council (2009-2010) Speaker/Advisor at Goldman Sachs, JP Morgan, Citigroup, Merrill Lynch and Lehman Brothers (2006-2009) Part-time Managing director at D.E. Shaw & Company (Hedge Fund) (2006-2008) President of Harvard University (2001-2006) US Secretary of the Treasury (1999-2001) Chief Economist at the World Bank (1991-1993) Professor at Harvard University (1983-1991) Fed experience None Political party Democrat Economic thinking Keynesian and not a great fan of rule-based monetary policy
Asymmetrically Hawkish (see next pages) Personal traits
Extremely intelligent and creative, Partisan, power player and not very diplomatic
Lawrence Summers is a flamboyant American economist who grew up in New Haven, Connecticut. He’s a nephew of two Nobel laureates in economics (Paul Samuelson and
Kenneth Arrow) and is himself often praised for his intellectual and creative thinking. He has a PhD from Harvard University where he also taught as a professor for nine years. After a stop in the World Bank, Summers became a dominant figure in Democratic policy circles, first serving as Bill Clinton’s treasury secretary (1999-2001) and later as director of Obama’s National Economic Council (2009-2010). He has close connections to the Clinton family and has a good relationship to President Obama, who has praised his work at the National Economic Council. His intellectual capabilities are highly recognised at Wall Street and hedge fund founder David E. Shaw has called him ‘a brilliant, brilliant guy’.
Summers’s biggest disadvantages are his lack of Fed experience and his unpopularity among many groups. Summers in particular got in trouble for many of his actions while he was President of Harvard University (2001-2006), which ultimately led to a faculty vote of no confidence. Many in the black community dislike Summers for his 2001- dispute with a Harvard-employed black professor. Feminists dislike him for saying (in 2005) that the cleverest of men are cleverer than the cleverest of woman. A large group found it wrong that Summers in 2005 let Harvard pay a USD28.5M lawsuit by the US government against a close friend and employee at Harvard who had traded Russian stocks using insider information. During Summers’s presidency Harvard also entered very speculative interest rate swaps, which lead to losses of USD1bn. Additionally, although Time Magazine named him a member of ‘the committee to save the world’ for his role in bailing out Asian companies in the Asian crisis in the 1990s, many Asian business people found Summers unnecessarily brutal and non-diplomatic. Lastly, many people dislike him for his close connections to Wall Street and his role in deregulating financial markets, which contributed to the magnitude of the financial crisis.
3 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
Yellen’s and Summers’s reaction functions
A dove vs an asymmetric hawk – an instrument consideration
There has been a tendency by the media to say that Summers will be a more hawkish Fed chairman than Janet Yellen due to his scepticism of quantitative easing. In our view this is a too simplistic characterisation.
Normally we would define a hawkish central banker as somebody who has bigger aversion to inflation than a dovish central banker who on the other hand has a large aversion to unemployment. If we think of Summers's and Yellen's preferences in terms of inflation versus unemployment we believe that both should be described as doves. Summers's outspoken support for significant fiscal easing indicates his strong aversion to unemployment. Similarly, Yellen has not only been a dove in the past five years - she has always been a dove. Furthermore, it is clear that Summers and Yellen agree that the main problem in the US economy is a lack of demand rather than supply side problems.
Hence, the difference between them is not really about what they want to achieve but rather how they want to achieve it. Both Summers and Yellen want to ‘stimulate’ demand to bring down unemployment and both would probably be relatively relaxed if a by- product turned out to be a slight increase in inflation - even in the longer run. The main difference between the two is rather how they want to achieve their targets. It is well-
known that Summers has been sceptical about the usefulness of QE, while Yellen has wholeheartedly supported it in the past five years. Summers; a fire-fighting arsonist?
Summers has several times indicated that he would be a fire-fighting Fed chairman – that is to consider a solution for each distinct problem. This self-confident approach blurs market transparency and the benefits from self-fulfilling central banking (as we have recently seen with Mark Carney, Governor of the Bank of England) are lost.
As Summers would not be a rule-following central banker, it becomes even more important for markets to figure out his reaction function. A paper - Fiscal Policy in a Depressed Economy - that Summers wrote with Brad Delong in 2012 might give us a clue about Summers's reaction function as a Fed chairman. The following quotations are particularly interesting:
‘There are limits to the efficacy of non-standard measures, so even if they were We are at the zero lower bound contracted, the impact is likely to be to only partially offset fiscal expansions.’ (p.41)
‘It seems to us that if fiscal policy is self financing it will be desirable to use as an instrument once it is recognized that (i) with uncertainty about multipliers diversification among policy instruments is appropriate as suggested by Brainard (1967), (ii) expansionary monetary policies carry with them costs not rep-resented in standard models (including distortions in the composition of investment, impacts on
the health of the financial sector, and impacts on the distribution of income), and (iii) the historically-clear tendency of low interest rate environments to give rise to asset Source: Macrobond, Danske Bank Markets market bubbles.’ (p.41)
This clearly shows Summers’s view that effects of unconventional monetary policy are limited and that fiscal policy is a superior instrument in a zero lower bound environment. In addition, as the second quotation highlights, he is also worried about other negative by- products of unconventional monetary policy, especially about creating asset price bubbles.
This we believe tells us something about Summers's reaction function. He might be a dove when it comes to unemployment aversion, but his aversion to certain monetary
4 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
policy instruments – particularly to quantitative easing – gives him a hawkish edge.
Yellen does not have this kind of reservation. Put differently, on the one hand, if we had fiscal stimulus with Summers as Fed chairman he would clearly be against offsetting the impact on aggregate demand with monetary policy. In that case he would be at least as dovish as Yellen - maybe even more so. If, on the other hand, fiscal policy was tightened he would not necessarily support an expansion of QE to offset the impact on aggregate demand. Hence, when the fiscal authorities are fiscally conservative, Summers will be hawkish (at the zero lower bound) and when the fiscal authorities are ‘Keynesian’ he will be dovish. In that sense we expect Summers to have an asymmetric reaction function.
As we see it, we may therefore never get to encounter the hawkish Summers if he becomes Fed chairman. If the recovery in the US economy continues - and speed of fiscal consolidation is slowed - he will likely be as dovish as Yellen. It is therefore only if we get another negative demand shock that the hawkish chairman Summers will emerge. In that scenario he will certainly also be setting himself up for a conflict with the Republicans as he will be saying ‘The Fed cannot stimulate aggregate demand anymore - the congress will have to approve the President's new fiscal stimulus plan’. As long as data improve both birds will fly in the same direction
The FOMC’s reaction function is important since the economic activity depends on the Economic conditions are improving actions of the Fed. The public is less uncertain when the FOMC conducts monetary 5 5 % y / y United States % y / y policy in a predictable manner. Since the Great Inflation in the 70s the FOMC has 4 4 followed some kind of Taylor rule depending on inflation and output/unemployment due 3 3 2 2 1 1 to the Fed’s dual mandate. Both Summers and Yellen are both dovish in the sense that 0 0 they are in favour of the current monetary policy keeping the interest rate low in the years -1 GDP -1 to come and are willing to accept more inflation in order to fight high unemployment. -2 -2 -3 -3 Their views on traditional monetary policy are not likely to affect markets significantly in 00 02 04 06 08 10 12 14 the years to come as the Fed’s fund rate has hit zero lower bound and economic conditions are improving. The most important difference between the two is their Source: Reuters EcoWin, Danske Bank Markets differing view on alternative monetary instruments in a zero lower bound environment.
Yellen supports using unconventional monetary policy tools like quantitative easing, while Summers is sceptical regarding its effect and is more likely to put pressure on the politicians to use fiscal policy to stimulate aggregate demand. This difference is important if the US is hit by a large negative shock in the coming years – otherwise we believe the difference in conducting monetary policy between the two will be minimal in the next years. It’s the communication, stupid.
It has become clearer that communication is alpha omega in the conduction of monetary QE exit strategy? policy, especially in a low interest rate environment. While not much is known about Summers’s communication strategy, we know much about Yellen’s view on communication of monetary policy. Yellen has chaired the FOMC’s subcommittee on communication and held a speech titled Communication in Monetary Policy on 4 April in which she stressed the importance of sound communication. Her main argument was that economic activity is tied to the public’s expectations about the future and hence must not be neglected. In her view communication is just as important a monetary policy tool as the traditional tool of changing the Fed’s fund rate. In particular she stressed that the Source: Macrobond, Danske Bank Markets nominal thresholds in the so-called Evan’s rule are huge improvements in the communication of the Fed’s forward guidance relative to the earlier time-dependent measure. She argued how the ‘low Fed’s fund rate in an extended period of time’ communication strategy was creating uncertainty regarding under what circumstances the FOMC would change the Fed’s fund rate. The FOMC’s communication and transparency remain important in the coming years as the Fed starts to scale back its QE programmes. Clear communication is needed in order to prevent uncertainties regarding the Fed’s exit strategy to affect the economy.
5 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
The end of the consensus era…?
One important task for the next chairman is to tackle a divided FOMC with different views on how to conduct monetary policy, how to use different instruments and in what direction the economy is heading. The current chairman Ben Bernanke is known for his hard work to reach compromises among the FOMC members. The consensus era has meant less uncertainty regarding FOMC policy and less divergence in statements from its members. On one hand, a less consensus-oriented Fed chairman will challenge Fed credibility, which may ultimately lead to greater market uncertainty. The transmission channel through expectations is as important as ever due to the ineffectiveness of the traditional interest rate policy when interest rates are close to the zero lower bound. If market expectations are not handled correctly, it is likely to make monetary policy less potent. In general Yellen is seen more as a consensus maker than Summers and as a result clear communication might take a hit with him in charge. On the other hand, it is important to note that with less focus on unanimous decisions the FOMC is likely to react faster. Current market reaction or lack thereof So who will win? The answer is not clear cut. Although Yellen has a commanding lead among economists polled by both Reuters and Bloomberg, the big global bookmaker Paddy Power has recently made Summers the clear favourite after Obama defending Summers at a closed-door meeting with Democratic members of the House of Representatives.
So far markets have not reacted to changes in the perceived likelihood of election. As pointed out this could reflect that both Yellen and Summers are expected to continue the current line in monetary policy. Nevertheless, we expect more uncertainty and volatility in markets in the case that Summers gets the nomination as his view on monetary policy is less clear.
6 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
Disclosure
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The authors of the research report are Lars Christensen, Signe Roed Frederiksen, Kristoffer Kjær Lomholt and Mikael Olai Milhøj
Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst’s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report.
Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request.
The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts’ rules of ethics and the recommendations of the Danish Securities Dealers Association.
Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high- quality research based on research objectivity and independence. These procedures are documented in Danske Bank’s research policies. Employees within Danske Bank’s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management
and the Compliance Department. Danske Bank’s Research Departments are organised independently from and do not report to other business areas within Danske Bank.
Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions.
Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request.
Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text.
Date of first publication See the front page of this research report for the date of first publication.
General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) (‘Relevant Financial Instruments’).
The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report.
The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change, and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report.
7 | 22 August 2013 www.danskeresearch.com
Yellen vs Summers Yellen vs Summers
This research report is not intended for retail customers in the United Kingdom or the United States.
This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank’s prior written consent.
Disclaimer related to distribution in the United States This research report is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to ‘U.S. institutional investors’ as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to ‘U.S. institutional investors’.
Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-U.S. jurisdiction.
Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non- U.S. financial instruments may entail certain risks. Financial instruments of non-U.S. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission.
8 | 22 August 2013 www.danskeresearch.com