Many people thought they would never see the day, but at long last there is a woman at the helm of the world’s most sacred institution.
No, not the Catholic Church. Something more infallible.
The Federal Reserve.
Confirmed by the Senate in January, Janet Yellen was sworn in on Monday as the first woman to chair the Fed's Board of Governors in its 101-year history.
In her first testimony as Federal Reserve Chair, she pledged before Congress to pursue the economic goals set by Ben Bernanke, her predecessor.
In the famously shrouded and clubby world of central banking—where women remain about as scarce as bailout jokes—Yellen’s confirmation represents a major breakthrough. But as historic as Yellen’s ascension is, being a woman is hardly her most identifiable trait. She is a big-time dove.
In central bank parlance, a dove is someone who is not so concerned with inflation. To understand why this is important, consider that the Fed has a dual mandate. Like nearly all central banks, it is charged with maintaining price stability—which today has come to be interpreted as an inflation rate of about two percent annually. But the Fed also has a second, less common goal: maximum employment.
These two objectives can be tense at times (like today). Easy money promotes job growth, but it also runs the risk of creating inflationary pressures. So-called inflation “hawks” prioritize keeping inflation low, even if it costs the economy some jobs. Doves, by contrast, are more inclined to flirt with higher inflation if it helps people get back to work.
During Yellen’s long and accomplished career, spanning Harvard, Berkeley, the White House, and multiple stints at the Fed, she has established solidly dovish credentials. Indeed, she is among the Fed’s loudest and most consistent supporters of helping the unemployed through monetary stimulus, at times pushing her predecessors, Ben Bernanke and Alan Greenspan, toward accommodation.
Leveraged strategically, Yellen’s reputation can help the Fed solve its biggest policy challenge today: tapering.
Backing Off on Bonds
Tapering refers to winding down the Fed’s extraordinary bond-buying program, known as QE3 or “quantitative easing.” The idea behind QE3, the third such round of quantitative easing (hence the “3”), is fairly straightforward.
In normal times, when the Fed wants to stimulate the economy, it buys short-term Treasury securities on the open market in order to lower the federal funds rate (the interest rate banks charge each other on overnight loans). Lower interest rates, in turn, increase borrowing and lending, spurring consumption and investment.
But we are not in normal times. Since the depths of the Great Recession in late 2008, the Fed’s target federal funds rate has been near its zero lower bound. In such a “liquidity trap,” conventional monetary policy is impotent. Interest rates can’t go lower than zero.
As a result, the Fed resorted to unconventional tactics to stimulate aggregate demand. First, it issued increasingly precise “forward guidance” about future policy actions, emphasizing rates will remain low for an extended period of time, even as the economy improves. In doing so, the Fed reduces market expectations about future interest rates, lowering long-term borrowing costs today.
Easing the Balance
The second tactic is quantitative easing, which refers to changes in the size and composition of the Fed’s balance sheet. It aims for the same objective as forward guidance—increasing economic activity in the absence of changes in short-term interest rates—but more directly.
Rather than purchase short-term Treasuries, as is the case with conventional monetary policy, QE targets debt that is longer-lived (longer-term Treasuries) or more risky (in the Fed’s case, mortgage-backed securities, or MBS).
The hope is that these purchases will reduce term premiums (the extra interest paid on debt that matures slowly) and risk premiums (the extra interest paid by riskier borrowers), respectively. Shrinking such spreads lowers borrowing costs, in principle driving economic activity.
At the same time, because balance sheets must balance, increases in the assets held by the Fed are matched by increases in the amount of reserves held by banks.
Before the 2007-2009 crisis, banks held less than $50 billion in reserves. Today, that number is more than $2.5 trillion. These reserves earn banks very low returns, so the hope is the swell of reserves will eventually push banks to increase the volume of lending, at last giving the economy the boost it needs to attain escape velocity from its persistent malaise.
Starving the Hawks
But this unprecedented stockpile of reserves is also what has the hawks worried. If banks get too eager to lend, the economy could overheat in a hurry, creating rapid inflation. Hence, the call for tapering.
Since its inception in September 2012, QE3 added $45 billion in long-term Treasuries and $40 billion in MBS to the Fed balance sheet each month. With the economy beginning to show signs of strength—unemployment is down to 6.6 percent, GDP growth occured for 18 consecutive quarters, and home prices increased by 4 percent last year—the Fed began tapering, reducing asset purchases by $10 billion. Last month, it cut another $10 billion—so now we’re down to $65 billion monthly.
Deciding the proper pace of tapering is a tough call. Some indicators have been positive, but not all is well, either. Labor force participation is at an historic low and long-term unemployment remains a serious problem.
In the coming months, Yellen and the rest of the Federal Open Market Committee (FOMC) will need to strike a delicate balance. Taper too slowly and the Fed risks courting damaging inflation. But taper too quickly and the Fed will undermine the already fragile recovery.
That’s precisely why the dovish credentials of the FOMC’s new Chair are so valuable. It creates an opportunity for stimulative tapering—that is, monetary tightening that leads to stimulus.
How exactly would that work? A primer, in three parts.
First, academic research suggests the most powerful channel through which QE operates is signaling. Apart from its direct impact on interest rate spreads and bank reserves, QE sends a message to markets that the Fed is committed to keeping rates low in the future. Think of it as a down payment on forward guidance.
Second, Yellen’s dovishness can plausibly substitute as a commitment device. Because her record makes clear she will not be shy about accommodative policy, the “putting your money where your mouth is” role of QE becomes less necessary.
Third, markets follow the Fed’s lead. When the Fed tapers, it sends a message that it believes the economy is gaining strength. Given the crucial role expectations play in the economy—together with the Fed’s unparalleled powers to effectuate its beliefs—Fed actions can become self-fulfilling prophesies. If the public gains confidence the economy is improving, it will.
Economic forecasting, like all forms of prophesy, is an inexact science, requiring intuition and faith as much as models and math. Fortunately, we’ve been given an incredibly skilled High Priestess.
In Yellen, we trust.
(For an accessible account of the economics of QE—and of the financial crisis more generally—I recommend Alan Blinder’s After the Music Stopped. Disclosure: I was taught by Professor Blinder, and he is every bit as engaging in person.)