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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

October 9, 2013 at 1:52 PM

The five biggest challenges facing Yellen

President Obama intends to nominate Janet Yellen as the next chairman of the Federal Reserve. Yellen, an economist and professor emerita at the University of California at Berkeley, is now the vice chairman of the Fed’s board of governors and will become the most important central banker in the world. She said all the right things today in a prepared statement, including:

While we have made progress, we have farther to go. The mandate of the Federal Reserve is to serve all the American people, and too many Americans still can’t find a job and worry how they will pay their bills and provide for their families. The Federal Reserve can help, if it does its job effectively. We can help ensure that everyone has the opportunity to work hard and build a better life. We can ensure that inflation remains in check and doesn’t undermine the benefits of a growing economy. We can and must safeguard the financial system.

Here are the most pressing issues she will face if confirmed by the Senate, when she takes office in 2014:

1. Politics. The Federal Reserve was established as a central bank that would be largely insulated from political pressure and for most of its history that’s the way it operated. To be sure, the Fed in the 1970s allowed inflation to get out of control because of subtle pressure from the White House and Congress to emphasize job creation. Now the pressure is out in the open. Members of Congress on the right and the left have criticized the Fed and demanded more accountability, including an audit. Yellen will have to defend the Fed’s independence.

2. A slow economy. Growth remains below the trendline compared with any post-World War II recovery and unemployment, officially at 7.3 percent, is high. There’s little evidence this will change for the better.  The Fed has a dual mandate to keep inflation low and employment high. Conventional monetary policy has failed to do that. Unconventional measures, such as the $85 billion per month buying of mortgage securities has helped — although it’s impossible to prove a negative (“What if the Fed had done nothing?”). Yellen will have a difficult time achieving the dual mandate, even though inflation is virtually non-existent, in such a slowdown. And she won’t get help from a federal government committed to fiscal austerity.

3. A divided board. Once upon a time, when Alan Greenspan was seen as infallible, the policy-setting Federal Open Market Committee fell into line on every policy, even when it was blowing bubbles that popped with disastrous effects. No longer. The FOMC has experienced considerable dissent about how to respond to the slow recovery, particularly over keeping so-called quantitative easing in effect. Yellen must build consensus between governors who worry that continued unconventional measures risk inflation, and others who argue the Fed should continue its aggressive intervention in the market.

4. Tapering. With a $4 trillion balance sheet of mortgage-backed securities and the formerly toxic assets taken off the books of the banks, the Fed will eventually have to return to a normal monetary policy. Unfortunately, the economy hasn’t been cooperating by returning to normal growth. Even rumors of tapering off QE are enough to send stock markets into sell-offs. Yellen must navigate an exit with consummate skill. No Fed chairman has ever faced such a conundrum.

5. The next recession. They hit about every seven years in the post-World War II era. To be sure, the economy is hardly in the territory of a big bubble (although full of small ones). It’s growing too slowly to provoke the kind of interest-rate hikes that traditionally caused downturns. On the other hand, the economy is very fragile and the financial sector is again engaged in excessive risk-taking. The Fed gained new powers to wind down systemically dangerous big banks (talk about redundant words) in a crisis. Yet this has never been done, and many experts aren’t sure it is even possible. Janet Yellen will likely be put to the test.

The legendary William McChesney Martin, who served as Fed chairman from 1951 to 1970, said it was the job of the central bank “to take away the punch bowl just as the party gets going.” Most Americans haven’t been having a party the past few years. But the Fed’s punch bowl is overflowing.


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