The past five years have featured some of the most interesting periods of United States Federal Reserve policy in the institution’s 100 year-plus history, and the next five should prove to be a more than worthy following act. As the recovery lumbers on, the elephant that has been lingering in the room is the interest rate and overall monetary policy adjustment. More specifically, when will Federal Reserve System Board of Governors Chair Janet Yellen decide to start raising the federal funds rate on overnight loans back to more normal levels, and what will she do to shrink the organization’s balance sheet from all the assets it bough up during the recession? The choices she makes over the next year to normalize monetary policy from its post-recessionary extremes could be the defining moments of her tenure, and have global repercussions.
The Interest Rate
The question that may dominate Yellen’s time at the Federal Reserve is what kind of effect the interest rate has on the overall economy. The federal funds rate, the rate at which banks can lend to each other through the Federal Reserve, is the Federal Reserve’s primary tool in enacting monetary policy, otherwise known as policy controlling the supply and demand of capital flows in the economy. The rate and direction of these capital flows is determined by this interest rate that one hears about regularly on the news. Lowering rates generally encourages banks to lend to each other, and is seen as a simulative policy.
Additionally, the interest rate is thought of as the cost of borrowing and reward of saving. The capital flows that the interest rate effects are primarily rates on bank loans, so the rates have a very large effect on the business world. If you lower the interest rate, conventional wisdom has it that since the cost of borrowing goes down, firms will invest more, and since the reward to saving is down, consumers will drive up domestic demand. The interest rates also exert a large control over Treasury bond bills, which havea large role in the direction of capital flows. Higher-yielding Treasury bonds are drivers of saving, as people will put more money into them if they are returning a higher rate. The past decade of monetary policy, if anything, has revealed it to be far from an exact science.
The 2008 crisis was so significant in scope that, according to Former Fed Chair Ben Bernanke, “September and October 2008 was the worst financial crisis in global history, including The Great depression.” To promote recovery, for the past few years the federal funds rate has been as close to 0 percent as it ever has been before. These low rates lead people to seek return on there money in investment vehicles besides Treasury Bonds, which has caused a record run up in stock prices during this post-recessionary period. In addition, in 2008, the Federal Reserve enacted quantitative easing, an unprecedented policy in which the Federal Reserve bought hundreds of billions of dollars worth of securities such United States Treasury Bonds to increase the money supply and keep interest rates from risisng for further stimulus. Quantitative easing has led to an explosion of the Federal Reserve’s Asset sheet. Both the asset sheet expansion and rate lowering were well under way by the time Yellen assumed office this past February, and she has been tasked with moving away from such policies as the economy strengthens.
The Challenges Ahead
Normalizing, however, will not be so easy. Michael Bordo, Distinguished Professor of Economics at Rutgers University, who has worked at central banks all over the world, said in an interview with the HPR that this is “an important and very interesting time, as we have never had such mixed signals from a recovering economy.” He noted that while there are signs of improvement, this one is far from normal, saying “We’ve had slow recoveries, but nothing ever this slow.”
In many respects, the data very much agrees with Professor Bordo. While the stock market has recovered and more, prompting fears of a bubble, the labor market has stagnated to a point where the CBO estimates that we are “6 million jobs short of where (we) would if the unemployment rate…returned to its precession levels.” It has never taken the economy this long to regain employment levels ever before. Yellen has been very vocal about this, from her opening testimony in front of Congress to more recent committee meetings. At every Federal Open Market Committee meeting or summit (Jackson Hole), she mentions the “significant slack” in the labor market as a reason to keep rates low. Additionally, she has bemoaned the “exceptional psychological trauma” of long term unemployment, adding a human element to rarely seen at the Federal Reserve. Despite this slack, however, the stock market has made an impressive economy.
This dichotomy between the recovery of the labor and stock markets has given Yellen a big challenge, Bordo continued. He says there is no doubt there will be some sort of dampening in prices in the future when Yellen raises rates, but is unsure of the outcome. He says, “There’s always the risk of low rate policy inflating the market, and there’s the risk the prices will go boom and possibly bust and cause a recession. However, with the market so high right now, when prices start to go down, the question will be whether it’s a correction, or a crash.” He warned a signicant crash could cause another contraction, much like the dot-com bubble in 2001.
All of these abnormalities in markets and policy across the boards have left Yellen in ucharted waters. Her navigation of these times will be precedent setting. In an interview with the HPR, national best-selling author and Wall Street Journal columnist Roger Lowenstein also pointed to “monetary largess” in the rise of the stock market. However, Lowenstein seemed to be less worried about the technicalities of rates and more worried with how Yellen will rebuild the fundamentals of the economy. His idea is that the overall confidence in the economy, and Yellen’s guiding hand, will play a larger role. He said, “It’s pretty easy to paint a scenario in the early 2000s where if did not have reckless mortgage financing, we would not have had such strong growth. So what will the basis of her policy be? What kind of economy are we?”
Harvard economist Gabriel Chodorow-Reich had a similar notion of policy uncertainty, telling the HPR “It’s anyone guess” in reference to how to conduct new monetary policy. He continued, “Whatever [Yellen and the Federal Reserve do] will be considered the new normal.” Much of Yellen’s future actions will determine this “new normal,” and the success of it.
Lowenstein was less worried about specific interest rate rises creating a bad business environment. He used the recovery after the recession of 1982 as an example to illustrate an economy with an uncertain future that will not necessarily be determined by the relative level of interest rates. Rates were exponentially higher than now, and so was growth, which is seemingly paradoxical these days. He said low inflation, among other things, has created an environment where companies are not confident enough to expand hiring at a healthy rate. “Companies aren’t seeing growth opportunities,” he summarized, “and animal spirits are low.”
The Yellen Legacy
Whatever decision she may make, a large part Janet Yellen’s legacy will likely be cemented within her first couple years in office, a highly unusual phenomenon among Federal Reserve Chairs. Alan Greenspan built up his reputation slowly as a believer in the true free market and was seen as the captain for its sailing until its failure in 2008. Bernanke came on during the Great Moderation, a supposed period where economists had beat the house and solved the business cycle. Yellen, on the other hand, has come into office in a time of evolving ideologies of the role of government in the market. She has had no time to build up a previous reputation, and no blessings of calm environment to ease her into her position. Lowenstein said, “Her main job is to revive the economy…If the labor market does not improve in the next few years, and wage growth is poor, she will likely be seen as a failure.”
Nick Colas of global trading firm ConergEx recently mentioned that “[Yellen’s] Federal Reserve will be known for how they unwound all this stimulus from the financial crisis.” No other factors were named, highlighting the importance of the year ahead for her. She will be judged in history for her ability to help Americans regain their confidence in the country’s future.
The relative unknown of how exactly to lead the economy forward has left the recovery in a precarious position, and Yellen is the one tasked with leading the country out through with confidence. Professor Bordo echoed some of Lowenstein’s sentiments of Yellen’s impact, saying, “Now is the time to normalize monetary policy, and it’s very important to see how she does.” However, he said it was “not realistic” to say that her entire legacy will determined by the next year or two. He said, “You don’t really know what’s going to happen [with the economy]. Bernanke’s career was ruled by unexpected events. Her legacy will only in part be determined by the next year.” With a recovery this slow, the time horizon for this crucial time in monetary policy may last much longer than a year, according to Chodorow-Reich. He told the HPR, “Equally important to the beginning of liftoff of the interest rate is how long it stays at certain levels-50 basis points or 100 basis points. In economic terms, that’s just as important as the first date of liftoff.”
As always, there are many opinions swirling around about the state of the economy and its Central Banker. However, there seems to be a notion that this is a critical juncture in the recovery, and the history of the Federal Reserve as well. All signs point to this being an incredibly distinctive time in monetary history. Never before has there been a crisis as unexpected as 2008, and never before has there been a recovery more complicated. Janet Yellen’s ability to handle this complexity looks like it will already be a defining feature of her tenure as Chairwoman, which has only so recently begun.