Yellen, if confirmed, faces daunting task as Fed chair
Commentary: Next chair must resolve our current economic woes and work to prevent another financial crisis
Janet Yellen listens as President Barack Obama speaks during a press conference on Wednesday to nominate her to head the Federal Reserve. Jewel Samad/AFP/Getty Images
President Barack Obama has nominated Janet Yellen to be the next chair of the Federal Reserve. This is arguably the most important economics job in the world, and if confirmed by the Senate, Yellen — currently the Fed's vice chair — would be the first woman to hold the position. The nomination comes after a heated behind-the-scenes race between her and Lawrence Summers for the job. The administration initially leaked Summers' name as its choice, which caused liberals on the Senate Banking Committee to revolt in favor of Yellen.
Even though it has been six years since the financial crisis began, 2014 will be one of the most consequential years for the Federal Reserve, and certainly the most important first year of a chair since the late 1970s, when the U.S. faced both high inflation and high unemployment. Next year will determine how we resolve our current fiscal and economic woes and rebuild to prevent future crises from happening.
Suppose we flash forward to New Year's Day 2015. How will we assess whether Yellen did a good job or not during the first year of her term?
The first way to judge is by looking at the two major numbers the Federal Reserve itself will be watching: unemployment and inflation. These numbers determine whether it is fulfilling its "dual mandate" of maximum employment and price stability.
Since the Great Recession started, the Fed has failed to meet its mandate. Everyone understands that unemployment, currently at 7.3 percent, is too high; but the core inflation rate, now 1.2 percent, has also been below where the Fed wants it. Indeed, that rate has been falling in 2013 well below the 2 percent target. And even now, experts at the Fed are projecting that unemployment will be around 6.6 percent at the end of 2014, with inflation (excluding certain volatile prices) below target at 1.6 percent. The question in 2015 will be whether Yellen can beat these projections and hit closer to target on either or both figures.
Another issue is how the Fed will exit the extraordinary measures it took to get the economy started again. In late 2012 it promised to keep rates low until either unemployment was below 6.5 percent or inflation was above 2.5 percent. However, economists are increasingly concerned that unemployment is dropping less because people have found jobs than because they have stopped looking for work and dropped out of the labor force. At his final press conference, departing Fed Chair Ben Bernanke emphasized that the unemployment rate "is not by itself a fully representative indicator" of economic well-being.
How Yellen will handle the Fed's recent, aggressive monetary policy as unemployment declines toward 6.5 percent will determine how swift America's recovery will be, or if it will even have one. If she raises interest rates earlier than necessary, it will mean less job growth and, in turn, an even more anemic recovery. Bernanke himself, before he became chair, thought the Federal Reserve could always boost the recovery as long as the chair did not fall into a "self-induced paralysis." Upon getting the chair, he fell into that paralysis for the first several years and refused to take more dramatic steps to jump-start the stagnant economy. By 2015, we will know how Yellen has reacted to the situation.
Preventing the next crisis
The second issue is whether Yellen will change the Federal Reserve to try and prevent another economic crisis of similar magnitude from happening in the first place. For the past 30 years, Fed officials believed that they had solved the problem of long recessions and that they could keep inflation very low and prevent the kind of mass unemployment we see now. That era, commonly known as the "Great Moderation," is now over.
This departure from the status quo has forced the Fed to improvise, creating new tools and policies on the fly to respond to ever-worsening economic news. As is evident from the prolonged misery of the Great Recession, resorting to the old techniques will not be enough. The tools at the Fed's disposal to stabilize the economy are likely to be overhauled. But how?
Some argue that we should pursue a higher inflation target to make a post-crisis slump like the current one less likely to happen. Others argue that we should accept higher unemployment and more sluggish recoveries, in favor of price stability or curbing Wall Street speculation.
Provided Yellen is not distracted by crisis management, she can shift economic policy toward a more liberal direction.
There is evidence that such steps are already being taken. At his last press conference, Bernanke mentioned that the Fed was considering a new tool, like a "floor," to prevent inflation from falling below a certain level. Meanwhile, the Fed will have to figure out what to do with the range of unorthodox tools and policies of the past several years. Even among people who supported Bernanke, many of these tools — such as promising to keep interest rates at certain levels until certain conditions are met, or purchasing mortgage bonds to adjust interest rates — remain controversial, because they were seen as too risky. This process will take leadership and guidance, traits Yellen has demonstrated when she persuaded then-Chair Alan Greenspan to not aim for zero inflation in the 1990s, as well as when she argued for bold actions, such as the purchase of assets from commercial banks to increase the money supply (so-called quantitative easing) during the recent recession.
Though these changes will take time, if at the end of 2014 the Fed has shown no willingness to prevent future liquidity traps — in which interest rates cannot be lowered any further but economic growth remains stagnant — a major opportunity will have been missed. And, going forward, even small recessions will likely cause major turmoil.
Financial reform also remains a serious issue for the next Fed chair. Major rules of the 2010 Dodd-Frank financial reform law have yet to be formulated. The Federal Reserve, one of the most powerful banking regulators, will probably have to break the deadlock over what needs to be done on the Volcker Rule, the portion of the law that separates hedge fund activities from normal commercial banking. There are additional important rules on capital reserves — the amount that banks will be required to retain to meet contingencies such as the credit freeze during the financial crisis — that remain to be proposed and will likely be delivered in rough draft by early next year. How aggressively Yellen supports the parties inside the Federal Reserve that want bolder action will determine whether the post-crisis effort to rein in Wall Street excess succeeds or fails.
In the 1990s, Yellen, like many members of President Bill Clinton's economic team, supported the removal of Glass-Steagall — the Depression-era law that separated investment banking from commercial banking — and she still supports that decision. However, she has recently spoken for more aggressive capital requirements than what international regulators originally suggested. She gave a speech this summer noting, in accord with Fed members who favor stronger reforms, that "it may be appropriate to go beyond the capital surcharges put forward by the Basel Committee" on international banking supervision, indicating that she wanted to force the biggest banks to have stricter regulations.
Although Yellen is eminently qualified to be Fed chair, her confirmation is not assured. While it is unclear whether Senate Republicans will block her candidacy, they have blocked many well-qualified candidates to other Federal Reserve seats, including Peter Diamond, who was awarded the Nobel Prize in economics while being blocked.
Also complicating her nomination is the question of whether the House Republicans' actions to shut down the government will trigger another recession or put substantially more stress on the economy. Yellen might walk into the aftermath of yet another crisis, this one self-inflicted by the government.
But provided she is not distracted by crisis management, she faces an opportunity to shift the course of economic policy toward a more liberal direction. Moves toward full employment, an economic policy responsive to the misery many Americans are experiencing, and a financial sector that better serves the needs of the real economy are big, but achievable, goals. By 2015, we will have a better sense of whether Yellen was the nominee to pursue them.
Opinions expressed here do not necessarily reflect those of Al Jazeera America.