- Yellen’s testimony before U.S. lawmakers will help clarify how she plans to govern the committee
- Some investors are expecting a meaningful change in direction from the Yellen Fed
- We look at four reasons why we anticipate continuity with the Bernanke regime
After a few bewildering weeks with Nicolas Maduro and Erdem Basci, I can’t be the only one grateful to be turning attention back to Janet Yellen. The new Federal Reserve Board Chair will make her first public appearance on Tuesday, February 11 when she testifies before Congress for the semiannual Monetary Policy Report (the “Humphrey-Hawkins” testimony). Investors have watched Yellen for many years, but this will still be a major moment. The testimony will help clarify how she plans to govern the committee, and how much airspace there was between Bernanke and Yellen on the big policy questions.
Janet Yellen has a reputation for being a dovish central banker—a characterization we agreed with in our lengthy primer on her views. As a result, some investors are looking for a meaningful change in direction from the Yellen Fed, starting with her remarks on Tuesday. We see several reasons why continuity with the Bernanke regime is more likely, at least out of the gates.
1. Reaction function has already moved a long way. As we documented in our earlier report, Yellen’s views have very often fallen on the dovish end policy debates during her tenure at the Fed. However, the committee as a whole has moved a long way since 2009—a theme we have referred to as the Fed’s shifting goalposts. What economists call the central bank’s “reaction function” looks much more dovish today—and much closer to Yellen’s world view—than it did a few years ago. Her optimal control approach to policy sounded aggressive in 2012, but is now close to the FOMC consensus. The characterization of policymakers as dovish or hawkish really only has meaning when compared to something else. And relative to today’s FOMC, Yellen does not strike us as exceptionally dovish.
2. Narrower views on participation rate. For a few years now, economists have debated how to interpret the decline in the labor force participation rate—the percent of adults that are either working or looking for jobs. Based on the growing pile of research notes on this topic in my inbox, it looks like the economics community is closing in on a rough consensus. This week’s report from the Congressional Budget Office (CBO) is a typical example. The authors estimate that two thirds of the decline in the participation rate since 2007 is structural, and one third “arose from temporary weakness in employment prospects and wages.” They add that the employment-to-population ratio will peak at just 58.9% in 2017—just one tenth above the level in January—before trending lower thereafter (in other words, it’s not reasonable to expect it to behave like the output gap).
Look for Yellen to stick close to this basic message, noting that the Fed sees some cyclical weakness in labor force participation, but that the decline also reflects long-term structural factors. Any other signal on this topic would be very surprising—and important from a market perspective—given the large body of research on the structural drivers of weak labor force participation.
3. Low inflation is not guaranteed. A common argument is that the Yellen Fed will be very slow to raise rates because modestly overshooting the inflation target is not a big deal, and in any case inflation is very low to begin with. We find both of these arguments a little puzzling. The financial crisis and its aftermath damaged the public credibility of the Fed—as recently articulated by former governor Kohn. Thus, we doubt policymakers are as blasé about overshooting the target as some market observers appear to think—there seems to be more at stake for the institution than can be calculated with a loss function.
Separately, today’s low inflation readings are of limited comfort. We see an analogy to driving a car: you can’t determine whether you have enough gas without knowing how far you need to drive. In the same way, the low rate of inflation needs to be considered in light of the long exit process ahead: it will be much too late to wait until inflation has rebounded to stop expanding the balance sheet. In Yellen’s testimony, look for this to come through in her comments about the tapering timeline.
4. There’s a committee to contend with. Lastly, although Yellen’s views will weigh heavily on the policymaking process, we doubt she will ignore the opinions of centrist policymakers—such as San Francisco Fed President John Williams, and possibly Stanley Fischer. How important this consideration will be remains to be seen, but we suspect that she may tack toward the center on Tuesday and in future public remarks.