All Things in Moderation

Janet Yellen testified in front of the Senate Banking Committee today and overall, there were few surprises. It is becoming clear that she intends to continue most of the Bernanke Fed’s policies, and to be honest I couldn’t find anything she would do differently. Her reception was generally good, and the Senators were respectful. Most of the questioning had to do with banking regulation, income inequality, the existence of asset bubbles and the size of the Fed’s balance sheet.

Here are some of the discussion points:

On current monetary policy: The Fed is seeking a strong and robust recovery, and must not jeopardize it by removing accomodation too early. She does not want to remove support while recovery is fragile. It is costly to withdraw accomodation or fail to provide adequate accomodation, and the Fed has the tools and the will to withdraw accomodation at the right time.

On asset bubbles: The Fed should attempt to detect asset bubbles when they are forming, however the first line of defense should be regulatory. Monetary policy is a blunt instrument and should be used if other measures aren’t working. She won’t rule out using monetary policy to address bubbles, but prefers that we use regulatory measures (such as increased capital requirements, higher risk retention requirements, etc) to prevent bubbles from occurring.  Separately, she sees little evidence that there are bubbles currently forming in the real estate market.

On banking regulation: Too Big To Fail imposes costs on the economy and should be avoided if possible. The government is making progress in handling too big to fail. They will raise capital standards further and the Fed is looking at requiring banks to issue additional unsecured debt at the holding company level to raise capital. She wants to ensure that the system isn’t set up to advantage the larger banks at the expense of the smaller banks.

On communication: In a nod to the volatility of the bond market over the summer, she said that she wants the Fed to communicate as clearly as possible with the markets and will redouble efforts to reduce volatility. This follows Bernanke, and is a departure from the Fed of the past, where they wanted to be as opaque as possible, lest the market anticipate what they were going to do, which would limit the effectiveness.

On QE and the balance sheet: Yellen was asked repeatedly about the effects of QE. She stressed that QE is being done to help the economy, not to help the government finance its deficit. When pressed about the size of the Fed’s balance sheet, she was forced to admit it is unprecedented for the US Central bank, but it was not unprecedented compared to other central banks. She acknowledged there are costs and risks to such a large balance sheet, and opposes any sort of Congressional audit of the Fed lest it reduce the Fed’s independence.

On income inequality: The Democratic Senators pretty much focused on income inequality, and what could be done about it. Yellen acknowledged that asset prices are rising, and that primarily benefits the rich, however the point of QE is to help the economy recover, and the best thing we can do for the middle class is to have a robust economy. She also acknowledged that QE is doing a number on seniors who rely on interest from safe assets to supplement social security. She views income inequality as a serious problem.

On the dual mandate: She stressed that the Fed must prevent inflation that is too low, and that deflation is a terrible thing. She refused to say what she thought “full employment” was, other than to give a range that it is probably in the 5% to 6% range. She also said that fiscal policy was working at cross purposes with what the Fed is trying to do. She also acknowledged that the reported unemployment rate understates the severity of the problem.

Key Takeaways:

While not admitting it, she seems to indicate the Fed goofed when it talked about withdrawing accomodation last June and causing the subsequent bond market sell-off. Expect the Fed under Yellen to be more communicative and she will probably try and clear up the confusion over tapering QE. It certainly seems she intends to err on the side of caution, provided there is no evidence of asset bubbles and inflation is at or below its 2% target rate.

The comment about full employment being in the 5% to 6% range was interesting as well. We spent many years over the past couple of decades with unemployment under 5% (it actually got below 4% in 2000). Does that mean the Fed will begin to start tightening before it ever gets to that level? Perhaps.

On asset bubbles, she does not hold the view that the Fed had a role in inflating the real estate bubble or the stock market bubble. Those bubbles were due to regulatory failure. It is ironic that the Fed has a problem with “too much money chasing too few goods” – in other words “inflation”, but is ok with “too much money chasing too few assets” – in other words a bubble. This is unsurprising; and suggests that the punch bowl might hang around a little longer than expected.

Filed under: Federal Reserve | 1 Comment »