In addition to her impending, and no doubt ultimately successful, quest for Senate confirmation, Janet Yellen will have a lot on her plate in the coming months. Now that House Republicans and Senate Democrats have come to yet another temporary agreement on the budget and debt ceiling, there still exists another threat to the economy: The Federal Reserve’s temptation to pursue an overly ambitious monetary policy aimed at offsetting the damage to the economy arising from poorly conducted fiscal policy. Now that President Obama’s Fed Chairman nominee has been announced, the Fed needs to shift its focus from wondering who will lead it to what its realistic goals can be. Substantially different views are held by Fed hawks and doves.
The economy is still on uncertain footing, and public frustration with the Fed is increasing, especially since the May-taper into September-no-taper serious misstep. The Fed seems to be making up policy as it goes along. It has become distracted with trying to fix problems it is not well-equipped to handle, including sustained lower unemployment and a faster pace of growth than is obtainable during a period of fiscal consolidation and weak global growth.
The Fed’s post-financial crisis mission creep, since 2008, has fueled an unhealthy codependence between it and the market, akin to the infamous pre-crisis “Greenspan put,” whereby the Greenspan Fed was expected to — and did — step in to support financial markets whenever there arose a threat to rising asset markets. Markets assume the Fed can and will fix any problems, such as the latest episode of Washington’s fiscal policy bungling, that might harm the economy or depress stock prices. Once necessary, but now dangerous, improvisations of monetary policy — quantitative easing and forward guidance in particular — have become alternately ineffective and counter productive, as the recent tapering trauma has shown. Yellen, as the primary author of the Fed’s new communication strategy, needs to identify ways to improve the Fed’s communication with markets and the public.
The Fed has come a long way since its founding one hundred years ago. Its original role was to be the lender of last resort in a financial crisis. That role, as a temporary emergency supplier of liquidity in a panic, has continued and should continue going forward. But in the postfinancial crisis period, the Fed has been forced to accommodate the extra cash demands of households and firms confronting a world of elevated uncertainty about the direction and conduct of monetary and fiscal policy. That is because higher uncertainty has forced firms and wealthy households to self-insure against possible bad outcomes and to preserve optionality in the face of unforeseen shocks and opportunities.
Failure by the Fed to satisfy higher cash demands worsened the Great Depression in the United States and the deflationary lost decade in Japan. These elevated, postcrisis cash needs explain why the Fed’s rapid additions to the monetary base through quantitative easing have been followed by disinflation, not inflation, as many have predicted. Chairman Yellen will have to be vigilant to avoid tightening too soon, while uncertainty remains high.