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The Senate recently confirmed that Janet Yellen would succeed Ben Bernanke as Chairman of the Federal Reserve. In addition to being the first woman Chairman of the Fed in its century long lifespan, she will also be the first Democrat to be seen leading it since Paul Volcker in 1979. Her unusual qualities of being openly reform-minded, Keynesian-oriented will bring a fresh new perspective to the Fed. Yellen’s appointment will undoubtedly bring substantial change in the way the Fed resolves economic issues.

 

Prior to being nominated for Chairman, Yellen had a successful, distinguished career in public finance and policy. She began her career with the Fed in 1994 when she was made a member of the Fed’s Board of Governors. Since then she has also held the positions of Chair of Clinton’s Council of Economic Advisors and President and CEO of the Federal Reserve Bank of San Francisco. In the four years before becoming the Chairman, Yellen served as Vice-Chairman under Bernanke.

 

Yellen has a mixed reaction with regards to monetary policy. In her first congressional hearing, Yellen stressed that the injection of stimulus into the economy has undoubtedly spurred economic growth by helping set course for a recovering housing market and renew investor spirit. Yet, Yellen has been more commonly known for her dovish stance on inflation, often stating, “monetary policy is not a panacea”. Generally, doves care less about the consequences of inflation and prefer to keep interest rates low to spur economic growth and reduce unemployment. Their counterparts, hawks, associate high inflation with recessionary pressure. They favor higher interest rates as a means of maintaining lower inflation. Yellen has also recently predicted moderate growth until at least next year and emphasized the need to look beyond the unemployment rate when assessing the economy. These judgments imply that Yellen plans on keeping interest rates low should the unemployment rate drop below the 6.5% threshold.

 

Both Yellen and Bernanke are both dovish on their stance on inflation and unemployment. Despite their somewhat similar economic ideologies, there is still a distinction to be made between Yellen and Bernanke. Bernanke has been described as more of a cyclical dove. Much of his policy had to do with injecting the economy with government money and keeping the needle in for as long as possible, but only when the economy showed signs of regression. Yellen, as a Keynesian and democrat, believes that government intervention is key and economic systems can be inefficient, making her more of a structural dove. Unlike Bernanke, Yellen believes the government should interfere in the economy not during certain points in an economic cycles but at all times.

 

As a dove, Yellen is not as inclined to react to economic downturn with increases in the Federal Reserve interest rate. However, economists from the research firm RDQ Economics predict she will focus on these issues differently. After heavily researching her papers, speeches, and various formulae, John Ryding and Conrad DeQuadros created the “Yellen Rule”, an equation that predicts the federal funds rates. The higher this rate is, the more expensive it becomes to borrow money. Because only the most credible institutions receive these short-term loans, the federal funds rate can be thought of as setting the base that determines all other interest rates in the economy, and ultimately, serves as a controller of inflation.

 

r = 13 + 1.5*p -2*U

 

r = federal funds rate

p = Fed’s preferred measure of inflation,

U = unemployment rate

 

To show how the formula works, with today’s inflation of 1.15 and an unemployment rate of 7.3, the federal funds rate set by the Yellen Rule would be 0.13. According to the economists Ryding and DeQuandros, the formula, and especially the coefficients on the variables p and U, demonstrate Yellen’s sensitivity to a decline in unemployment. They claim after studying her speeches and papers during her time at U.C. Berkeley, the Federal Reserve Bank of San Francisco, and as Vice Chair of the Fed they have found evidence for a hawkish attitude towards inflation. For example, if employment were to improve, they claim that it is possible that Yellen may call for a rapid rise in the federal funds rate. What does this equation mean and what are its implications? It does not show that she contradicts herself, but rather that she is open minded and will react to economic fluctuations by what she deems most appropriate, a flexibility that will make her an excellent Chair for the Fed. Furthermore, her recent statements have proved that she sees inflation not rising anytime soon, indicating her dovish desire to keep the federal funds rate low.

 

Yellen will have several obstacles to overcome as she begins her first term as Chair of the Fed. For certain, the economic conditions that Yellen now has to address are drastically different from the ones in Bernanke’s time. During his two terms, the housing bubble burst, Lehman Brothers went bankrupt, and AIG had to be bailed out, among other economic disasters. It was evident in 2008 that the U.S. economy was in tremendous turmoil; Bernanke would need to take aggressive action to revive the economy from a recession no former Chairman had to face since the Great Depression. Bernanke dropped the federal funds rate to a near 0% and spent over $700 billion in bailing out banks and large corporations, measures that surpass all past anti-recession efforts. When the financial crisis of 2008 had finally been averted, every action Bernanke took was focused on ensuring the economy would not slide back into a depression and moving it in the right direction. The endeavor of the Fed paid off as the unemployment rate is at a low of 6.6% and stock markets have been at an all time high as of January 2014. Due to the moderate success, Bernanke attempted to taper the quantitative easing policy by $10 billion per month to $75 billion per month. In January 2014 the Fed continued this trend and tapered back its policy by another $10 billion to $65 billion per month.

 

This brings us to Yellen’s situation. No longer is the country in danger of falling into the grave depths of economic depression. Though the economy is no longer in recession, it is still of absolute importance that we see a continuous upward trend. Unfortunately, growth has retarded, as only 74,000 non-farm payroll jobs have been created within the month of December and 2013 saw a meager 1.3% growth rate due to fiscal tax increases and spending cuts. In January 113,000 jobs were created, falling short of the expected 185,000. Yellen has acknowledged that the economy is still weak stating, “The recovery in the labor market is far from complete,” and, “the unemployment rate is still well above levels that [we monetary policymakers] estimate is consistent with maximum sustainable employment.” The unemployment rate has fallen to a low since October 2008, but the cause of this is not a rise in employment but a loss in workforce. A more accurate graph shows the actual percentage of citizens that hold jobs, which has not seen substantial increase.Chad Stone. “The Fed Must Continue to Fight Unemployment.” U.S. News. February 15, 2014.

 

Yellen has many issues in ensuring the economy remains stable in addition to continuing Bernanke’s most recent project in tapering government involvement in financial markets. Yellen will have to ensure both the economy and markets are kept steady while tapering back some of the government lending policies, as such action can cause investors to lose confidence. Due to the quantitative easing initiatives of the Bernanke terms, Yellen will be knee deep in a balance sheet that now exceeds $4 trillion. Timing will be essential for Yellen as she continues to combat a struggling economy and a huge deficit.

 

Another matter to consider is the issue of inflation. The current goal of the Fed is to attain an inflation rate of 2%, a goal government officials failed to meet in the past two years. Inflation that is too low for an extended amount of time puts the country’s economy at risk for a negative hit of deflation. This may also cause households to postpone purchases in expectancy of lower prices and companies to delay hiring and investing since demand for products will fall. In addition, higher inflation-adjusted interest rates will ensue, resulting in a difficult environment for economic growth.

 

So what are her plans? One is an idea known as “optimal control”, in which the Fed would raise and lower interest rates in a more scientific and analytical manner. Specifically, government economists would create and incorporate a macroeconomic model that would mathematically calculate the ideal path of the short-term interest rate, controlled by the federal funds rate, necessary to reach inflation goals and unemployment targets. In the current economic situation, Yellen would act to keep the federal funds rate low longer, ultimately resulting in unemployment dropping faster and inflation increasing above the Fed’s goal for a few extra years.

 

Unfortunately, because the Fed is not perfect in analyzing and predicting the economy and because inflationary psychology, where consumers will buy quickly with expectations of a rise in price, occurs from a lack of trust in the Fed to control prices, this “optimal control” is not realistic. Yellen, therefore, also considers a simpler rule, better known as the Taylor Rule, which sets the interest rate only based on the divergence of inflation and economic output from their targets. But, the downside to this formula is in how it calls for rates to rise sharply very fast after periods of economic weakness. There are both clear advantages and disadvantages to both strategies, making it evident that Yellen will also have to use the good judgment we have seen her develop all these years in making these important decisions.

 

More generally, Yellen has shared her thoughts on how she would go about ensuring economic security through accommodative financial conditions, a strategy she helped create. This involves supporting consumer spending, business investment, and housing construction as a means of adding more momentum to recovery. As long as labor markets and inflation steadily improve, she has all intentions of continuing the monthly $10 billion dollar cutting of Treasury securities and agency mortgage-backed securities. Of course, she will nevertheless continue to be wary of labor market and inflation as economists and critics assess the efficiency of the government purchases.

 

In order to avoid another credit crisis-like debacle, she intends to do differently to what Bernanke and his predecessor did: ameliorating the damages once the bubble inevitably crashed. Instead Yellen’s plan is to actively try to prevent reckless spending by auditing bankers’ loan books. She once also said she did not rule out the use of higher interest rates, though her higher preference is clearly tighter regulation.

 

Only time will tell exactly how Yellen will proceed to catalyze growth in the economy. Though during Bernanke’s term the inflation rate never reached the Fed’s goal, Bernanke endeavored to mend America’s economy with heavy intervention and did in fact prevent it from utter turmoil. Yellen will now have to face low employment rate, low inflation rate, and the withdrawal of the stimulus package of bonds. Considering her past success as a government official, and especially her recent position as Vice-Chair of the Fed, there is no doubt that she has enough knowledge and experience in macroeconomics to perform superbly. Her determination to lower the unemployment rate is reassuring, as it demonstrates her desire and prioritization to combat unemployment. Yellen’s weaponization and meticulous use of the federal funds rate and the tapering of the quantitative easing will be sure to bring about a change in the economy, one that will hopefully lead America back to a thriving, booming economy.

Written by thefinancier

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