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Yellen Promises Continuity and Change at the Fed

A leading advocate of the central bank’s bond-buying policies, Janet Yellen’s big challenge will be deciding when to wind them down.

Janet Yellen greeted a visitor with a firm handshake and got right down to business. Seated at a table in a spacious Federal Reserve Board office, her hands calmly placed over a folder full of notes she had no need to consult, Yellen proceeded over a little more than an hour to calmly and methodically make the case for the central bank’s quantitative easing policies.

It was August 2012, and I was visiting the Fed to report a story on the extraordinary monetary policies being pursued by the Fed and other major central banks, and the risks that endless bond-buying and zero interest rates could fail to revive the economy, or foster fresh asset bubbles. Yellen was unfailingly prepared, precise and polite, explaining in clear language why the Fed’s dual mandate obliges it to do everything possible to stimulate growth and employment while inflation remains subdued. QE was having an impact, depressing rates and yield spreads, but it wasn't a panacea and it carried risks of its own, she acknowledged.

“It’s hard to see what buttons we can push to get the economy back to full employment in 2014,” she said. Asked when the economy and the yield curve might get back to normal, Yellen didn’t sugar coat it; four to five years, she said, is her hope and reasonable expectation.

Considering that the financial crisis began five to six years ago, depending on your preferred starting point, Yellen’s prognosis virtually implies a lost decade for the U.S. economy. On the other hand, it would mark a successful Fed chairmanship, assuming she wins Congressional approval for a four-year term beginning in February following her nomination by President Obama on Wednesday.

Yellen represents a strong degree of continuity in U.S. monetary policy, a factor that reassures many market analysts and investors. Like Ben Bernanke, the current chairman, who taught economics for two decades at Princeton University before moving to the Fed, she is an academic at heart, having taught at the University of California Berkeley. She has been an ardent proponent of QE and the use of forward guidance to indicate to the market that rates will remain very low for a very long time to come, leading a dovish wing that includes Bernanke, New York Fed President William Dudley and Chicago Fed president Charles Evans. And she is arguably the most-experienced nominee ever, having worked in the 1970s as a researcher at the Fed (where she met her husband, the Nobel prize-winning economist George Akerlof), returned as a Fed governor in the ‘90s, chaired the Council of Economic Advisers under Bill Clinton and then served a decade as president of the San Francisco Fed before coming back east as vice chairman in 2010.

Yellen is no knee-jerk dove, though. She persuaded Alan Greenspan in the ‘90s that the Fed shouldn’t aim to eliminate inflation, arguing that it would run the risk of deflation, but she has been equally adamant in ruling out an increase in the Fed’s 2 percent inflation target, contending that is both impractical and would risk undermining the Fed’s credibility. She also suggested a tougher stance toward regulation, a growing priority for the central bank. She expressed early concerns about housing prices while at the San Francisco Fed, even if she never pressed for action to rein in the sector. Recently, she has indicated a desire to ratchet up capital requirements on too-big-to-fail banks on top of the surcharges contained in the Basel III capital accord.

Yellen will need to reconcile the tensions between the Fed’s two mandates at a crucial juncture. Doubts about the efficacy of QE, which Bernanke and Yellen admit has diminishing returns, have grown in recent months as the Fed’s balance sheet has ballooned. At the same time, the economy’s momentum has slowed and the fiscal standoff between the Obama administration and the Republican House of Representatives could trigger a new recession if it gets out of hand. The Fed’s decision not to start tapering its bond purchases last month was a close call, and a vocal group of Fed regional presidents remains strongly opposed to the bank’s continued bond purchases. “I’ve never seen a committee as divided as this,” says Laurence Meyer, a former Fed governor and senior adviser at Washington-based forecasting outfit Macroeconomic Advisers.

Bernanke’s very collegial style backfired when, to appease the hawks, he spelled out exit scenarios at his June press conference. That move persuaded financial markets the Fed would start tapering bond purchases in September, sent interest rates soaring and triggered massive capital flight from emerging-markets economies. Three months later, the Fed blinked, concerned by the volatility it had unleashed.

Minutes of the Federal Open Market Committee’s September 17-18 meeting, released Wednesday, underscored the policy divide inside the Fed that Yellen will have to breach. One camp expressed worries about a slowing recovery and growing risks stemming from rising interest rates, others contended that the labor market had improved over the past nine months and that a failure to taper, as most market participants were expecting, could “undermine the credibility or predictability of monetary policy.” The decision to maintain bond purchases at the rate of $85 billion a month was “a relatively close call,” the minutes stated.

Global policymakers in Washington this week for the annual meetings of the International Monetary Fund and the World Bank are nervously eyeing the Fed, and the debt ceiling standoff between the Obama administration and House of Representatives Republicans, to see if they will spark fresh volatility. Joyce Chang, head of global fixed-income research at J.P. Morgan, told an IMF panel on monetary policy that the Fed needed to send clearer signals to markets about its exit strategy to minimize market turbulence.

Can Yellen handle internal Fed politics and external communications any better? It won’t hurt that her forecasting record in recent years has been better than any of her colleagues, according to a recent survey by the Wall Street Journal. Her patient, no-nonsense, data-driven approach should also help. “She’s rigorously empirical as opposed to doctrinaire about it, which is what you want in your Fed chair,” wrote Jared Bernstein, an economist at the Center on Budget and Policy Priorities and former chief economist to Vice President Joe Biden, in response to news of her expected nomination.

Yellen will also mark a notable, chromosonal, change at the Fed, set to become the first female chief in the central bank’s 100-year history. No one knows if the skills that enabled her to break the Fed’s glass ceiling can help her better manage its policymaking processes, but it will focus all the more attention on the central bank chief at a critical time.

“Tonight, I feel reassured that my daughter’s economic future is in good hands,” Justin Wolfers, an economist at the University of Michigan, wrote on his blog. “I also plan to tell her that she, too, can grow up to become the most powerful economist in the world.”

Whether that’s powerful enough to invigorate the world’s largest economy remains to be seen.

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