New Maestro, Seasoned Band

Global Central Bank Focus February 2014 Tony Crescenzi

Your Global Investment Authority

New Maestro, Seasoned Band

My first memory of witnessing the Federal Reserve’s power to move markets is of a Thursday afternoon in the spring of 1983. I was at my first Wall Street job in an office full of stock brokers in downtown New York, just a few hundred feet from the New York Stock Exchange. It was at the end of the day, and a crowd of anxious brokers were standing beneath the ticker tape at the front of the room, watching the news feed, with pen and paper in hand. I had no idea why.

Then – at precisely 4:30 p.m. – there was a burst of noise. Curious, I asked a broker. He said that the Fed had just released its weekly money supply data. Huh? He described how Wall Street waited every Thursday with bated breath for the data because the Fed set interest rates by adjusting the money stock. In technical terms, the Federal Reserve operated under a reserve-targeting regime, adjusting the quantity of money to determine its price – the interest rate level. The more money there was, the lower its price went. When money was scarce, interest rates rose. No wonder Thursdays at 4:30 were a veritable sporting event. Today, the Fed operates differently, targeting a specific interest rate and adjusting the quantity of reserves accordingly. In reality, this isn’t completely true because the Fed, through its bond buying, has injected trillions of dollars into the financial system without any intention of having the money affect its policy rate because it can’t – the rate is at zero. Instead, the injections determine the effective policy rate, which is at some unknown level below zero, and they are meant to suppress interest rates and interest rate volatility, thereby compelling investors to move outward along the risk spectrum. This means that the new 4:30 is the Fed’s bond buying, in particular its pace of tapering, because of how it will affect views about the timing of future rate hikes. There’s a bigger point in all of this, which is to highlight the ever-changing nature of the Fed’s influence on markets evolving from its 100-year history. Still, one thing is constant: its ability to move markets. How it does this changes, but its basic goals and objectives don’t change much. A key point of this article is to highlight how the process by which the Fed carries out its duties has been institutionalized, is firmly rooted and is unlikely to change, no matter who is at the helm. Change at the top: Enter Janet Yellen The Federal Reserve characterizes its duties into four Ever since President Woodrow Wilson signed the Federal main categories: Reserve Act at 6:02 p.m. on 23 December 1913, the Federal 1. Conducting the nation’s monetary policy by influencing Reserve has been evolving into one of the most powerful the monetary and credit conditions in the economy in institutions in the U.S and the world. The Act itself has been pursuit of maximum employment, stable prices and refined and other laws have been passed to shape the Fed moderate long-term interest rates into what it is today. 2. Supervising and regulating banking institutions Fourteen individuals, beginning with Charles S. Hamlin in 1914, 3. Maintaining the stability of the financial system and preceded Janet Yellen as Fed chair containing systemic risk that may arise in financial markets (Figure 1). Each evolved the Fed in 4. Providing financial services to depository institutions, response to the issues of the day, the U.S. government and foreign financial institutions, and today the Fed operates in a including playing a major role in operating the nation’s vastly more complex system than it payments system once did. Yet, there are constants, and the central bank’s ultimate The Fed has carried out these duties for decades, and despite raison d’etre as a lender of last much change, including at the helm, continuity and the power resort is as clear as ever. of the institution take precedent. This is true today more than ever, because after a century of experience encompassing the FIGURE 1: CHAIRMEN OF THE FEDERAL RESERVE Great Depression, World Wars, financial crises, globalization and complex changes to the financial system, the nation’s 1 Chairmen Date of term central bank has evolved accordingly and it can draw from its Charles S. Hamlin 10 August 1914 – 19 August 1916 experiences. Much of the Fed’s future conduct will therefore W.P.G. Harding 10 August 1916 – 9 August 1922 be dictated by its past. Daniel R. Crissinger 1 May 1923 – 15 September 1927 The power of the institution Roy A. Young 4 October 1927 – 31 August 1930 Eugene Meyer 16 September 1930 – 10 May 1933 When Janet Yellen was nominated Fed chair, many focused on how she differed from her predecessor, Ben Bernanke. Many Eugene R. Black 19 May 1933 – 15 August 1934 still do. This is appropriate but only to a point. When Janet Marriner S. Eccles 15 November 1934 – 31 January 1948 dons her cloak as Fed chair, her actions will be guided by Thomas B. McCabe 15 April 1948 – 31 March 1951 powerful precedents, including the central bank’s plethora of Wm. McC. Martin, Jr. 2 April 1951 – 31 January 1970 experiences, the institutionalization of its processes, its success Arthur F. Burns 1 February 1970 – 31 January 1978 in acting as a lender of last resort and its hard-won gains in G. William Miller 8 March 1978 – 6 August 1979 achieving price stability. Paul A. Volcker 6 August 1979 – 11 August 1987 Two questions need answering. First, what is engrained in the Alan Greenspan 11 August 1987 – 31 January 2006 Federal Reserve as an institution that will guide Janet Yellen Ben S. Bernanke 1 February 2006 – 31 January 2013 as she carries out the Fed’s duties? Second, is Yellen bigger Janet Yellen 1 February 2014 – than the institution, her position as Fed chair or the financial markets? The answer to the latter question is: Of course not! 1The active executive officer of the Board. This position was known as “Governor” until the passage of the Banking Act of 1935 and as So, stay focused on the institutional elements that will guide “Chairman” thereafter. the Fed chief’s policies. Source: Federal Reserve

2 FEBRUARY 2014 | GLOBAL CENTRAL BANK FOCUS Here are six of the most prominent of these elements: Today, unemployment (and under-employment) is elevated and inflation is near its lowest level since record-keeping Culture of collegiality: For an organization filled with 200 began in 1960 (Figure 2), which is why Yellen’s Fed can be ambitious Ph.D.s, the Federal Reserve is surprisingly collegial, patient in reducing its highly accommodative stance on and Janet Yellen is described as Miss Collegiality. The Fed’s monetary policy. top minds, many of whom are staffers advising the Fed’s top brass, work together in a flat structure to formulate the best FIGURE 2: INFLATION IS NEAR HISTORICAL LOWS possible policies. Price deflator for core personal consumption expenditures Decision by committee: Arguably one of the least effective (year-over-year % change) chairmen was G. William Miller, who was Fed chief for just 12 17 months from 1978–1979. His belief that high inflation 10 would self-correct was unpopular at the Fed. In fact, the 8 Board of Governors in 1979 voted against Miller in favor of raising the discount rate. That experience reinforced the 6 importance of the Fed chair forming a consensus and 4 honoring decisions by committee. Dissents since then have been relatively low. To be sure, the Federal Open Market 2 Committee (FOMC) often coalesces around the chairman’s 0 views, but the chairman never decides on his own. Nov Nov Nov Nov Nov Nov 1963 1973 1983 1993 2003 2013 Diverse and robust structure: It’s called the Federal Reserve Source: Bureau of Economic Analysis System for a reason. The System comprises the Board of As of 30 November 2013 Governors and 12 regional Federal Reserve Banks. The Board and Reserve Banks share many responsibilities, including Crisis-ready: In response to the financial crisis, the Fed created supervising and regulating banks and providing banking a wide variety of credit and liquidity programs known as services. Reserve Banks themselves have robust structures, and “alphabet soup” programs because of their acronyms. These they provide important input to the FOMC on the economy. tools are at Chair Yellen’s disposal to help her and the Fed The Board consists of seven members appointed by the navigate through a variety of challenges. President of the U.S. and confirmed by the Senate. The Board Hard-won gains in achieving price stability: In contrast to combines with five Reserve Bank presidents to form the FOMC. the 1970s, today the Federal Reserve has enormous credibility Board members have permanent votes, but there is an annual as an inflation fighter. The proof? Despite all of the Fed’s rotation of four Reserve Bank presidents (the president of the money printing, consumer surveys indicate household inflation New York Fed has a permanent vote), ensuring a diversity of expectations are low. Even more convincing is the $1 trillion opinions. Moreover, nonvoters participate at FOMC meetings. market for Treasury Inflation-Protected Securities (TIPS). It Dual mandate: The Fed can’t stray far from the objectives shows investors expect the consumer price index to increase Congress gives it, which are stated as follows in the 1977 just 2.27% over the next 10 years. Low Treasury yields show amendment to the Federal Reserve Act: further confidence in the Fed. Janet Yellen has contributed to this confidence, voting as a member of the FOMC to increase “The Board of Governors of the Federal Reserve System and interest rates 27 times. Yellen is no G. William Miller! the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate The first woman Fed chair understands the important role with the economy’s long run potential to increase production, that price stability plays in fostering economic and financial so as to promote effectively the goals of maximum employment, conditions that promote strong labor market conditions. stable prices and moderate long-term interest rates.” Mind you, the attainment of price stability means protecting

GLOBAL CENTRAL BANK FOCUS | FEBRUARY 2014 3 also against an inflation rate that is toolow , which is why Change can be unsettling and it creates uncertainty, but when today’s low inflation rate (Figure 2) will be one of Janet an organization such as the Fed has the structure, processes Yellen’s most important guiding lights. and experience to carry on and take on new challenges, it can thrive and improve its ability to take on whatever comes its Winston Churchill had it right way. Janet Yellen enters a position shaped by 100 years of “There is nothing wrong in change, if it is in the right direction. experience, and is well prepared to lead the Fed through the To improve is to change; to be perfect is to change often.” next set – a comforting thought for investors. Good luck, Janet! Winston Churchill, 23 June 1925, House of Commons

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