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Fixed-Income Insights

What could investors expect from a Federal Reserve led by Janet Yellen?

(First of two parts.)

The debate over the qualifications of Janet Yellen versus Larry Summers as the next chair of the Federal Reserve has made for interesting summer reading. Yellen, the current vice chair of the central bank, and Summers, former Treasury secretary, economic advisor to President Obama, and president of Harvard University, have been widely reported as the front-runners to succeed departing chairman Ben Bernanke. Many discussions have offered a line-by-line resume comparison of the two prospective candidates.1 Some have placed policy questions firmly in the backseat to focus on the historical aspect, as Yellen would be the first-ever female Fed chief.2 Others have noted the novelty of a standing Fed vice chair being tapped for the top job at the world's preeminent central bank.

Given that very few of the polity get a direct vote on this matter (this is a political appointment by the White House, subject to approval by the Senate), a more relevant discussion may be what to expect under each of the two perceived front-runners. The following analysis (to be published in two parts) will examine the two leading candidates in terms of how the Fed may change under their respective leadership. First, we'll discuss what investors may expect from a Yellen-led Fed. The second part will discuss what a Fed under Summers might look like.


Yellen: Keeping QE on Course

Yellen's characterization as a policy dove is grounded in her advocacy of a zero interest rate policy and quantitative easing (QE), combined with some tolerance for inflation. Since 2010, Yellen as Fed vice chair supported Chairman Bernanke's leadership and the central bank's unconventional monetary policies during a trying time for the economy. What's more, she was recognized as a key contributing architect of those policies. Accordingly, with Yellen in charge, the policies and the criteria cited for their modification or reversal are not likely to deviate from the plan articulated by Bernanke so frequently since May 2013.

In fact, Yellen emphasized in a February 2013 speech that a zero interest rate policy might be appropriate even after the Fed reached near-term targets for inflation or unemployment.3 She also was among the first members of the policy-setting Federal Open Market Committee (FOMC) to characterize the targets as "thresholds for possible action, not triggers... [to] prompt an immediate increase,"4 a theme repeated frequently since then. So from a policy perspective, a Fed under Yellen seems likely to follow the course most investors understand and expect, including the criteria and speed with which current aggressive easing actions are likely to be unwound—and eventually reversed.

If anything, her tolerance for inflation may be greater than other FOMC members, especially in the context of an economy needing stimulus. This willingness to abide a modest amount of inflation is supported by history. As a Fed governor, Yellen argued that the Fed should avoid an overtightening of monetary policy in 1996.5 As president of the San Francisco Federal Reserve Bank, she maintained that the central bank should focus on economic growth, not just inflation, as the Fed's "predominant policy concern" in 2007.6

A Clearer View on Policy
A second major characteristic of current Fed leadership—transparency of Fed intentions—also seems likely to remain unchanged should Yellen replace Bernanke. In fact, Yellen leads the committee created by Chairman Bernanke to improve policy communications. It was the "Yellen Committee" that encouraged the introduction of the Fed's mission statement, inflation target, and anonymous forecasts by each participant in the FOMC for the benchmark fed funds interest rate.7 Under Yellen's leadership, we can safely expect a continuation of policy transparency and likely more reliance on Fed releases and speeches by Fed officials as tools to manage investor expectations.

Given Yellen's leadership in communications, one change that she may direct is greater uniformity of Fed messaging among public comments made by Fed members. This would help to avoid confusion about Fed intentions when well-articulated minority views are given equal weight with the Fed consensus. Such confusion has led to market volatility on several occasions in 2013.

When It's Time to Shift Gears...
Some critics appear to be concerned about Yellen's ability to shift from the Fed's current ultra-accommodative policies in time to avoid consequences of excess leverage or risk-taking that may be by-products of aggressive easing. Some comfort may be taken, however, in Yellen's policy contributions in 1994 through 1996, when she served as a Fed governor under Alan Greenspan's chairmanship. At that time, the Fed successfully tightened policy to avoid a flare-up of inflation, and then eased in time to avoid a "crash landing" for the economy. FOMC meeting transcripts reveal Yellen's contributions during this time, in particular her efforts to avoid over-tightening.8

Yellen's involvement in this well-executed and successful policy shift at least reveals both willingness and experience when it comes to a timely reversal of policy. Of course, economic conditions are quite different now, so the prospective Fed leader may find shifting the policy levers somewhat trickier when the time comes.

Banking on Tougher Regulation?
Finally, with regard to the Fed's role as bank regulator, Yellen may not be as soft-spoken as her critics suggest. Her warnings as San Francisco Fed president in 2005 of poor real estate lending practices that included 100% loan-to-value ratios, or failed to include sufficient documentation, produced a response from the Fed that was so weak that, according to Yellen, "You could... rip it up and throw it in the garbage."9

Yellen was proven correct in her concerns by the subsequent mortgage crisis. This factor could reinforce a preference for providing others the Fed guidance or even regulation that Yellen was looking for in 2005, but did not get. This experience may tilt Yellen's hand toward clearer guidance and potentially stronger regulation. One potential clue as to how a Yellen Fed may approach bank regulation may be gleaned from the Center for Public Integrity's recent review of her record as a bank regulator. The center's conclusion was featured as the report's title, "Yellen as Fed Chair Would Be Tougher on Banks."10

"Yellen, Summers, and the Fed's Future, Part II," will examine what a Lawrence Summers-led Fed might look like.


1 Alan S. Blinder, "Janet Yellen Is the Best Fed Choice," The Wall Street Journal, July 28, 2013.
2 Timothy Noah, "Why Janet Yellen Is the Sexist—That Is, the Better—Choice for Fed Chair," MSNBC, July 26, 2013.
3 Janet L. Yellen, "A Painfully Slow Recovery for America's Workers: Causes, Implications, and the Federal Reserve's Response," Board of Governors of the Federal Reserve System, February 11, 2013.
4 Ibid.
5 Binyamin Appelbaum, "Possible Fed Successor Has Admirers and Foes," The New York Times, April 24, 2013.
6 Blinder, op cit.
7 Craig Torres and Jeanna Smialek, "Yellen Signals Fed Would Maintain Easing After Halting QE," Bloomberg, February 12, 2013.
8 Appelbaum, op cit.
9 Staff audiotape of interview with Janet Yellen, Financial Crisis Inquiry Commission, November 15, 2010.
10 Alison Fitzgerald, "Yellen as Fed Chair Would Be Tougher on Banks," Center for Public Integrity, June 28, 2013.

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