Speculation about who will succeed Ben Bernanke as head of the Federal Reserve Board is at a fever pitch. Speculation about whether the Fed will start to taper its bond buying in September has reached a similar intensity. In fact, the two events are closely related, in ways that say more about the latter than the former.
The Fed race has turned into a virtual public brawl in recent weeks between supporters of front-runners Lawrence Summers and Janet Yellen. This open campaigning is unprecedented but not surprising. The Fed chairman is arguably the second-most-powerful person in government — and the only U.S. economic policymaker with any real freedom of maneuver given the stalemate between the Obama administration and the Republican-led House of Representatives. In his news conference Friday (Aug. 9), President Obama said the choice was “one of the most important economic decisions I will make” in the remainder of his presidency. Bernanke’s background as a Great Depression scholar, his willingness to rip up the conventional central banking playbook and his canniness in forging a consensus on controversial and largely untested policies helped contain the Great Recession and put the economy back on a tentative recovery track. His successor’s actions may well decide whether the economy reaches escape velocity or suffers a Japan-style lost decade — or worse.
So there’s a lot at stake, which explains why seemingly every economist and pundit with a soapbox has weighed in on the contest. Does the Fed need a truly brilliant economist with a proven ability to think outside the box in a crisis? That’s what Brad DeLong, a University of California, Berkeley, economist and former Clinton administration official, asserts in support of Summers. Or does it need someone who was prescient in warning of the systemic risk of subprime mortgages and consistently correct in predicting a subpar recovery, as James Hamilton, an economist at UC San Diego, suggests in advocating the choice of Yellen, one of the leading doves behind the Fed’s quantitative easing policies and forward guidance on interest rates.
Others descend to caricature. Critics deride Summers as a bullying, deregulating tool of Wall Street, whose hand in repealing the Glass-Steagall Act makes him partly to blame for the crisis. Yellen is dismissed as an aloof academic who has no market experience and lacks gravitas — the new euphemism for the Y chromosome.
Exaggerations? Certainly. In fact, there’s much more that unites Summers and Yellen than divides them. As Keynesian economists, both see a role for the government in smoothing the business cycle and intervening in crisis situations. Sure, in his few notable recent comments on monetary policy, Summers has expressed skepticism about the impact of quantitative easing and argued that what the U.S. economy really needs is fiscal stimulus, but the key word is “stimulus,” not “fiscal.” The chances that Congress will agree to boost spending are lower than the chances of Nassim Taleb becoming the next Fed chairman (1,000 to 1, by the way, according to online betting site Paddy Power).
It’s clear where Obama’s preference lies. Summers was his chief economic adviser through the worst of the crisis, and the president has an obvious comfort level with the former Harvard University president.
Yellen is another story. The onetime UC Berkeley economist has been Fed vice chairman since October 2010, has led the charge to advocate unconventional monetary policies and has had a better track record than any of her colleagues at forecasting the economy’s poor performance. By those measures she should be a slam-dunk choice to succeed Bernanke. That Obama hasn’t done so already suggests he’s unlikely to give her the nod. The president hinted as much on August 1 by defending Summers at a meeting with congressional Democrats.
At his news conference, the president praised both Summers and Yellen as “outstanding candidates” and dismissed one questioner’s suggestion that he favored his former economic adviser, saying he was merely defending Summers against unfair attacks the way he had defended Susan Rice last year. Considering that he ended up abandoning plans to nominate Rice as secretary of State, the comparison could only worry the Summers camp. Obama was even clearer on his selection criteria. The next chairman must understand the Fed’s dual mandate and realize that the overriding challenge today is unemployment, not inflation. Both Summers and Yellen would readily agree. The comments provided the clearest sign yet that this is a two-horse race. In his August 1 meeting with congressional Democrats, he had floated the name of Donald Kohn, Yellen’s predecessor as vice chairman, as a third candidate, but that was most likely a head fake to keep the race open a little longer.
Why drag out the process? That’s where the taper comes in. After five years of extraordinary monetary easing, Bernanke jarred markets in May and June by telling Congress that the Fed might begin reducing its $85 billion in monthly bond purchases later this year and end QE by the middle of 2014. That is several months earlier than most analysts were expecting, and it sent yields on the Treasury’s benchmark ten-year note surging by more than 80 basis points, to 2.73 percent. Since then Bernanke has dialed back his rhetoric, warning recently against undue tightening by the market. His more dovish comments, combined with a disappointing July employment report and sluggish second-quarter GDP figures, have brought bond yields back down to just under 2.60 percent as some investors have pushed back their taper expectations to December.
Don’t bet on a delay. First, the economic data isn’t as bad as some think. Despite the soft July employment number, nonfarm payrolls have risen by an average of 192,000 a month this year, just shy of the 200,000 mark that the Fed considers a sign of a healthy labor market. A strong rise in the Institute for Supply Management’s nonmanufacturing index in July suggests the economy retains good forward momentum.
More important, the Fed has undergone a subtle shift in emphasis on QE since the spring, one that emphasizes the potential risks of bond buying as much as its benefits. New governor Jeremy Stein signaled the shift in a February speech warning that QE might be fostering asset bubbles by driving investors into riskier assets in a search for yield. That was music to the ears of Fed hawks like Dennis Lockhart, president of the Atlanta Fed. Bernanke’s hints of an early taper suggest he shares those concerns. A taper-friendly speech by Chicago Fed president Charles Evans, who has helped shape the QE program, on August 6 suggests the doves are getting on board. Backing away from a September taper in the absence of clear weakness in the economy would risk wrong-footing the markets again and casting doubt on the recovery.
It would also risk punting the issue to Bernanke’s successor. Obama needs to nominate a candidate soon to replace the chairman when he steps down at the end of January. No one in the Fed or the administration wants a nominee to go through congressional confirmation hearings while markets and the Fed are debating the first exit move from QE — one with huge consequences for the economy and the Fed’s credibility.
“What is the best gift he can give his successor? To make the tough choice,” says Laurence Meyer, senior managing director of Macroeconomic Advisers and a former Fed governor. “This is the toughest choice the committee will have to make for the next year or year and a half.”
All of this indicates that a decision to start scaling back bond purchases will be made at the September 17–18 meeting of the Federal Open Market Committee, followed shortly by Obama’s announcement of a nominee. With luck, the new chairman — whether Summers, Yellen or a surprise third choice — can keep a steady hand on the tiller until it’s time for the next big decision: when to start hiking rates.
