On Feb. 1, Janet Yellen will become the chairman of the Federal Reserve. Considering that the Federal Reserve System just celebrated its 100th birthday and employs more Ph.D. economists than any other institution on earth, you’d think it would have monetary policy down pat. It doesn’t. Yellen herself acknowledges that setting interest rates sometimes involves groping in the dark. “I consider it essential, in making judgments about the stance of policy, to recognize at the outset the limits of our understanding regarding the dynamics of the economy and the transmission of monetary policy,” she said in a 2012 speech to the Money Marketeers of New York University.
Yellen is wise to be humble, as just about every issue she will confront is fraught with uncertainty. Is the U.S. economy stagnating, or threatening to overheat? How quickly should the Fed taper its purchases of long-term Treasury bonds and mortgage-backed securities? When should it begin to raise the federal funds rate, which has been nailed to the floor at zero to 0.25 percent since the end of 2008?
These debates are typically viewed through the familiar hawk-vs.-dove monetary prism, but they are deeper and more interesting. Here’s a guide to three of the Big Questions that will keep Madame Chairman occupied in the years ahead:
Lev Pontryagin, born in Moscow in 1908, was 14 years old when his family’s kerosene stove exploded, blinding him, yet he became one of the greatest mathematicians of the 20th century. Among other things, he built the foundation for optimal control theory, which explains how to maximize the effectiveness of a process given constraints on cost or time. In 1953 the American Richard Bellman developed a variant called dynamic programming that became a mainstay of science and engineering—it was even used for landing the Apollo Lunar Module.
Yellen has repeatedly expressed fascination with the possibility that the Fed could “optimally control” the U.S. economy by raising and lowering interest rates in a more scientific manner. Under the optimal control approach, Fed economists would use a macroeconomic model to calculate the mathematically ideal path of short-term interest rates needed to hit established inflation and unemployment targets.
If Yellen started channeling Pontryagin and got the rest of the Federal Open Market Committee to buy in, short-term interest rates could stay near zero longer than anyone is expecting. In her 2012 talk to the Money Marketeers, she flashed a “purely illustrative” graph of what the economy might look like under optimal control. The Fed would keep the funds rate low longer, and unemployment would fall faster. Inflation would rise slightly above the Fed’s target, but only for a few years. Overall, that’s much better than the current outlook.
There is a catch, and Yellen is the first to admit it. Optimal control assumes that the Fed has perfect foresight and flawless data about the economy, and also that inflationary psychology never takes hold, because businesspeople and consumers unfailingly trust the Fed to keep prices under control. That’s not realistic, of course. So Yellen in her 2012 presentation also considered a “simple rule” that prescribes an interest rate based on nothing more than available data about the divergence of inflation and economic output from their targets. (This is the Taylor Rule, named after conservative economist John Taylor of the Hoover Institution.) The Taylor Rule is more straightforward but has its own drawback, Yellen told the Marketeers: After periods of extreme weakness like the past few years, it calls for rates to rise too much, too soon.
In other words, you can have a rate-setting rule that’s very good but unreliable, or one that’s reliable but not very good. Some choice. “A dose of good judgment will always be essential as well,” Yellen concluded. That’s also known as trusting your gut.
Low rates are intended to jump-start growth, but they can inflate bubbles as investors pump borrowed money into stocks, real estate, and other assets. At the Jan. 6 vote to confirm Yellen, Senator Charles Grassley, an Iowa Republican, said “the stock market has become addicted to the Fed’s easy-money policies.” (The Standard & Poor’s 500-stock index rose 30 percent in 2013.)
Ben Bernanke and his predecessor, Alan Greenspan, long argued that bubbles were impossible to identify in advance and that, in any case, it was better to clean up the mess after they popped than to raise rates preemptively, causing collateral damage to the real economy. The intellectual foundation for that doctrine was damaged by the worst economic downturn since the Great Depression, when the overpriced housing market collapsed.
Yellen is still averse to popping bubbles with costlier money and argues that the best way to prevent reckless lending is scrutinizing bankers’ loan books. But Jeremy Stein, a fellow member of the Fed’s Board of Governors, said in an influential speech last February that regulation and supervision can miss some abuses, in contrast to tighter monetary policy, which he said “gets in all of the cracks.” Two months after Stein’s speech, Yellen reiterated her “strong preference” for using regulation to fight bubbles but didn’t rule out the “blunt instrument” of higher rates.
Transparency or Mystery?
Yellen has left no doubt about which side she takes in the transparency debate: She’s been a leader in pushing the Fed to set and communicate its targets for inflation and economic growth. It was she who called for quarterly press conferences by the chairman well before she knew she would eventually become the one fielding reporters’ questions. In Yellen’s view—as well as Bernanke’s—transparency is a new way for the Fed to restore growth. Businesspeople might be afraid to invest if they think the Fed might raise interest rates next month, chilling growth. By revealing that it intends to keep short-term rates close to zero for a long time to come, the Fed can induce more investment, hiring, and growth.
Oversharing by Fed officials, however, can create more heat than light. Markets gyrate whenever a policy board member says something that might possibly imply a change in the pace of tapering of bond purchases or a tightening of the federal funds rate. Speaking to reporters last December, Philadelphia Fed President Charles Plosser lamented the “uncertainty that we’ve created.” Also, promising to keep short-term rates low is an invitation to asset managers to speculate with borrowed money, Anil Kashyap, a professor of economics and finance at the University of Chicago Booth School of Business, said earlier this month at the annual meeting of the American Economic Association. Warned Kashyap: “It could cause a day of reckoning.”
Monetary policy aside, regulation is a huge issue for Yellen. The U.S. still hasn’t reached agreement with other nations on a reliable system for handling the failure of big global banks. And as economists Anat Admati and Martin Hellwig wrote last year in The Bankers’ New Clothes, banks continue to pose a risk to taxpayers, because their safety cushion of equity is too thin.
Running a central bank looks easy: Just turn the knob on rates once in a while or adjust bond purchases a bit. But a lot of thought goes into those tweaks. Consider the old joke about the engineer who took one minute to replace a faulty part that had shut down a large factory and then presented a bill for $1,000,001. “Why so much for one little part?” his manager asked. “One dollar for the part,” the engineer said, “1 million bucks for knowing to replace it.”