Investment Insight November 2013

Authors WHAT TO EXPECT FROM FED CHAIR YELLEN

IN BRIEF • The US Federal Reserve’s monetary policy under Janet Yellen will be broadly similar to monetary policy under Ben Bernanke, but we expect some important differences. Erik S. Weisman, Ph.D. Fixed Income Portfolio • Yellen is likely to emphasize consensus less and her own views more, resulting in greater Manager transparency along with clearer and more forceful forward guidance. • Unlike her predecessor, Yellen is a strong advocate of including rules-based approaches to determining monetary accommodation. • She will look for a broad-based improvement in labor market indicators before recommending that quantitative easing should be tapered. • Her academic research supports her belief that the high unemployment since the ! nancial Robert Spector, CFA crisis has been largely cyclical rather than structural. Institutional Portfolio Manager • The implication is that Yellen may place a heavier weight on one part of the Fed’s dual mandate (employment) than on the other (price stability).

President Obama has nominated Janet Yellen, the current vice chair of the US Federal Reserve, to replace current chair Ben Bernanke, whose term expires in January. This is a relatively rare changing of the guard: Over the 100 years since the Fed was created, only 14 men have served in this role, and there have been times when the Fed chair has arguably been the most in" uential person in the world. Indeed, the names Bernanke, Greenspan, Volcker and Burns all conjure up powerful impressions, replete with monetary policy successes and failures. Yellen comes to the job with strong academic and policymaking credentials, having earned a Ph.D. in economics from Yale and faculty appointments at Harvard and the London School of Economics. She also chaired President Clinton’s Council of Economic Advisors and the Economic Policy Committee of the Organization for Economic Cooperation and Development from 1997 to 1999. She has more Fed experience than Bernanke had when he became chair, having served on the staff of the Federal Reserve Board of Governors in the late 1970s and again as a member of the Federal Open Market Committee under Chairman Alan Greenspan in the mid-1990s before becoming president of the BUILDING Federal Reserve Bank of San Francisco in 2004 and vice chair of the Federal Reserve Board in 2010. BETTER Comparison with previous Fed chairs ® While Yellen’s nomination has generally been seen as a signal of policy continuity, she will be different INSIGHTS from her two immediate predecessors. Many believe that she will be less dictatorial than Greenspan, who dominated FOMC meetings by speaking ! rst, but less deferential than Bernanke, who typically speaks last during policy meetings in an effort to reach a broad consensus. Like Greenspan, Yellen will be inclined to state her own view with her own voice, yet she is unlikely to run the Fed in such a

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centralized fashion. Like Bernanke, she will strive to maintain a Quantitative easing collegial atmosphere in which other FOMC members are permitted Of the other tools at her disposal, Yellen has expressed her to express their opinions. But rather than seeking consensus at con! dence in the ef! cacy of the third round of quantitative the expense of policy design or transparency, she will probably easing — the Fed’s monthly $85 billion purchases of longer-term tolerate more dissent if that can lead to a better outcome. As a Treasuries and mortgage-backed securities — and her belief that result, Yellen’s Fed may lie somewhere between Greenspan’s and the bene! ts of QE have so far outweighed the potential costs. Last Bernanke’s in terms of the policymaking process. spring she found no pervasive evidence of any ! nancial imbalances Setting the federal funds rate is typically considered the primary job or negative market impacts, although since then, MBS market of the chief US central banker. But with the rate targeted near zero functioning has been somewhat impaired as the Fed’s MBS buying and likely to stay there as long as labor markets and in" ationary has arti! cially pushed down yields, which ultimately pass through expectations remain so subdued, the job for Yellen may be more to markedly lower mortgage rates. While she does recognize that about using the other monetary policy tools at her disposal, QE could threaten ! nancial stability by promoting excessive risk- namely quantitative easing and forward guidance. taking, in her view that might not be so problematic in the current environment of extreme risk aversion. Optimal control By contrast, several FOMC members have expressed concern In recent speeches, Yellen has discussed rules-based approaches about the size of the Fed’s balance sheet. According to the minutes to determining appropriate monetary policy. Over the past two of the September meeting, most participants would have been decades, Fed watchers have looked to the Taylor rule for a gauge comfortable reducing the pace of asset purchases starting this of how the central bank should adjust short-term interest rates year and ending in mid-2014, and a number of policymakers were to guide in" ation and unemployment toward the Fed’s targeted disappointed by the decision not to begin tapering in September rates.1 Rather than focus on the typical Taylor rule, under which and by the lack of transparency about that decision. the deviation of in" ation and unemployment from Fed targets It seems likely that a Yellen Fed may start to taper asset purchases are given equal weight, Yellen refers to a version she calls the later and at a slower pace. As for the actual timing, she has “balanced approach” rule, which doubles the weight on the offered ! ve speci! c measures to guide her overall view about unemployment gap compared to the in" ation gap — a sign improvement in the labor market outlook: the unemployment rate, that she may place a higher weight on one side of the Fed’s dual payroll job growth, the hiring rate, the quit rate and the economic mandate than on the other. She also introduces “optimal control” growth rate. Several of these measures have improved under QE, techniques to derive a prescribed path for the policy rate based on but not by enough. She has not indicated whether she believes a forecast of economic conditions.2 Thus, she is focused on several MBS or Treasury purchases are more effective in stimulating the rules-based approaches. economy or which she would taper ! rst. Yellen has stated that in a Yellen advocates considering these approaches simultaneously, crisis, all available tools should be employed to help bolster private since simple rules such as the balanced approach perform well credit markets, but once the economy is back to normal, the Fed under ordinary circumstances but may be challenged in times like should eventually return to a Treasury-only balance sheet. these, when persistently strong headwinds continue to restrain the economic recovery, even with the federal funds rate held Forward guidance near zero. And she has noted that optimal control simulations to Another increasingly important tool for the Fed is forward minimize the deviation from the Fed’s objectives are sensitive to guidance, the ability to set expectations by clearly signaling model speci! cations and to potentially unrealistic assumptions. its future intentions. A big proponent of transparency, Yellen Nevertheless, Yellen believes that over the next several years, the has presided over major policy changes as head of the FOMC Fed’s dual mandate of maximum employment and stable prices subcommittee on communications, including persuading her may be better met under optimal control, even though the policy colleagues of the need for the chair’s quarterly post-meeting commitment may appear suboptimal along the way. Speci! cally, press conference. Fed messaging should be more straightforward in" ation would be allowed to persistently overshoot the 2% target with Yellen as chair, with less scope for the kind of confusion that as long as that would help bring unemployment down to 6.5% surrounded the decision not to taper in September. more quickly. Yellen believes that the Fed should give explicit forward guidance Yellen also believes the real neutral federal funds rate may be about holding rates “lower for longer.” She has strongly endorsed substantially below its historical average, which suggests a more outcome-based guidance predicated on thresholds for speci! c accommodative policy path than current consensus expectations.3 macroeconomic variables as a major improvement over calendar- More precisely, she argues that when the Fed actually hikes the based guidance that is date speci! c. In keeping with this emphasis, policy rate, the terminal rate may be quite a bit lower than the 5% the Fed has adopted a clear 6.5% threshold on the unemployment to 6.5% range reached in the late 1990s or mid-2000s. rate, with the provision that projected in" ation should stay within

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one-half percentage point of its 2% target before the Policy implications Fed would consider raising rates. However, both Bernanke The nomination of Yellen as Fed chair resolves the uncertainty and Yellen have suggested that there could be some latitude about Bernanke’s successor that was evident in confusing forward around these objectives. guidance and bond yield volatility earlier this year, and should pave Her ! rst task as Fed chair may be strengthening the guidance the way for a smooth transition in the conduct of monetary policy around QE tapering — in particular, leading the market away from if she is con! rmed without delay. She has strong quali! cations in expecting asset sales to be a meaningful part of the exit strategy. economic forecasting and academic analysis, and appears to be If Yellen supports such enhancements to forward guidance in the more comfortable than her predecessor with tension and dissent future, she could continue the Fed’s evolution from Greenspan’s among the diverse members of the FOMC. intentional obfuscation and Bernanke’s consensus-driven speci! cs During her career at the Fed under both Greenspan and to her own analytical and empirical model-driven transparency. Bernanke, including the three years that she has served as vice chair, Yellen has become known as an excellent communicator Cyclical or structural unemployment? and a leading advocate of Fed transparency. Despite the widely The labor market has been a focal point of Yellen’s long career held opinion that she is ideologically predisposed to be ultra- as an academic and as a policymaker. Her research into the dovish, those who know her well claim she is only that way causes and implications of unemployment explains how frictions because the current situation of stubbornly high unemployment in labor markets, including deviations from " exible wages and demands it, and she could be far more hawkish if in" ation rises prices, prevent the ef! cient allocation of labor. Work with her because of capacity constraints. husband George Akerlof, a Nobel laureate economist, asserts that As we have found with her predecessors, Yellen’s intellectual anticipated shocks to aggregate demand affect real output and foundation can serve as a guide to what kind of Fed chair she produce cyclical variations in unemployment. Akerlof and Yellen will be. Greenspan’s belief in the ef! cient functioning of the argue that after such shocks, the economy returns to equilibrium free market turned out to be his greatest strength but also his slowly, suggesting a role for monetary policy in smoothing output weakness. He presided over the economy while it achieved full " uctuations and limiting involuntary joblessness. potential in the 1990s, but only at the expense of creating multiple Given her academic underpinnings, it is not surprising that Yellen asset price bubbles. After his tenure at the Fed, he identi! ed the views the elevated unemployment rate during the post-! nancial problem with the low premium on risk before the ! nancial crisis in crisis recovery as caused mostly by cyclical rather than structural the late 2000s, but wrongly assumed that ! rms would act in their factors. She occasionally refers to broader measures of labor own self-interest. underutilization, such as the U-6 measure that counts among It is too early to write the history book on Bernanke. Clearly the total unemployed those marginally attached to the labor his research on the Great Depression in" uenced his sense of force and those working part time for economic reasons. By urgency in pulling us back from the abyss, and the ! rst round way of comparison, the U-6 unemployment rate was 13.6% in of QE in 2008 – 2009 has been widely viewed as a success. September, well above the headline rate of 7.2%. For Yellen, a key But his insistence on consensus at all costs has prevented him justi! cation for highly accommodative monetary policy has been from articulating any revisions to his own views between FOMC to avoid hysteresis, that is, when a cyclically high unemployment meetings, which has weakened Fed transparency and limited rate gradually turns into a structural problem of lower labor force forward guidance. Moreover, successive rounds of QE have participation, even as the broader labor market improves. succeeded in boosting nominal prices on assets such as equities, Like other dovish FOMC members, she is more apt to describe commodities, housing and farmland but have failed to ful! ll the the Fed as missing its mandate in terms of too high employment promise of creating robust growth in GDP, employment or wages. rather than too low in" ation. She has reiterated that with in" ation Yellen’s strong belief that easy monetary policy can be an effective running below the 2% objective and employment so far from a tool for reducing unemployment — even at the expense of higher desirable level, it is appropriate for progress in the labor market to in" ation — is grounded in the Phillips curve, the historical inverse take center stage in the conduct of monetary policy. This emphasis relationship between in" ation and unemployment. This framework on employment rather than in" ation is quite a change from Fed dominated economic policymaking during the 1960s and 1970s, policy over most of the past three decades, when in" ation has when monetary accommodation was intended to boost growth been the focus. Yellen has even argued that in a deep recession, and employment with some tolerance for higher in" ation. The amid high and prolonged unemployment, in" ation expectations experiment did not end well, and it took double-digit interest could get stuck at low levels. This would justify using monetary rates and a deep recession in the early 1980s to mark the close of policy to boost output without being overly worried about raising the in" ationary 1970s. Since then, US in" ation has been low and in" ation, which is the predominant concern among the hawkish stable. Yellen’s success as chair may depend on whether her faith FOMC members.

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in the Phillips curve leads to complacency on in" ation. In the This is an important question, because if joblessness is mainly absence of wage in" ation, this framework is unlikely to be as structural, then wage and in" ation pressures may emerge at a damaging as in the 1960s and 1970s, but it may still cause other higher rate of unemployment and a slower pace of economic problems, including the emergence of more asset price bubbles. growth than in past cycles. Yellen would be challenged to react We can easily imagine a whole host of unintended consequences to above-target in" ation and below-target growth. Certainly associated with this overly easy monetary stance. the equity and bond markets would deliver their verdicts in such a scenario. Long-term yields could rise materially if the Fed is What we also know from the tenures of Greenspan and Bernanke perceived to be behind the in" ation curve, and stocks typically fare is that both faced crises — sometimes quite early in their ! rst poorly in a stag" ationary environment. terms. Greenspan took the helm in August 1987, and the stock market crashed two months later. He was also forced to confront The answer to this important question may lie in Yellen’s call for the Asian crisis in 1998 and the tech bubble in 2000 – 2001. a balanced approach within the context of using monetary rules Bernanke became Fed chair in February 2006, just as the housing for policy: While monetary policy can signi! cantly reduce high bubble was about to burst, and in its aftermath he was forced to unemployment by stimulating demand, such stabilization policy deal with the global ! nancial crisis. should be complemented by policy that just as vigorously ! ghts in" ation when it rises above the target. If Yellen can ! nd the right If it turns out that Yellen has taken the wrong side on the cyclical balance, she will turn out to be neither a dove nor a hawk, but a versus structural unemployment debate, she could face her ! rst pragmatic and effective Fed chair. major test. Would she be " exible enough to change her views?

1 Stanford economics professor John Taylor’s original 1993 version of the rule prescribes that the federal funds rate should respond to the deviation of actual inflation from its longer-run goal and to the difference between actual GDP and estimated potential GDP, or the output gap. The economy should be close to full employment when the output gap is closed. 2 In a June 2012 speech, Yellen describes this alternative approach, which is “to compute an ‘optimal control’ path for the federal funds rate using an economic model — FRB/US, in this case. Such a path is chosen to minimize the value of a specific ‘loss function’ conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate.” 3 According to Greenspan (1993), the real funds rate may be said to be neutral when it is at a level that, “if maintained, would keep the economy at its production potential over time.” Therefore, if the real funds rate is below the neutral real rate, policy is accommodative and the economy expands; if it is above the neutral real rate, policy is restrictive and the economy shrinks.

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