With Larry Summers having withdrawn his name from consideration as Federal Reserve Chairman, it is all but certain that President Obama will name current Fed Vice Chairwoman Janet Yellen to be the next Fed Chair.
Before delving into what a Yellen Chairmanship means for the markets, it is worth noting the level of political sophistication and genuine care about the well-being of the U.S. economy demonstrated by Dr. Summers. Knowing that President Obama felt a great deal of loyalty to him, Summers was obviously concerned that he would be nominated to be Fed Chairman even if it was not best for the administration or the economy. This recognition and his effort to avoid a political battle that would be detrimental to President Obama and the institution of the Federal Reserve demonstrates a level of selflessness and self-awareness that many commentators have claimed Summers lacks. So, I commend Dr. Summers for doing the right thing in this situation.
Turning to likely Fed Chair nominee Janet Yellen, I should note that it was almost a year ago that I first deemed Yellen a frontrunner for the job. While many have viewed Yellen as an extension of Bernanke, her leadership will likely bring some minor, but notable policy changes. These changes include:
- A greater effort to build consensus on the FOMC.
- An increased focus on forward guidance.
- More detailed Fed communication than ever before.
Yellen is already known within the Fed as having formidable bureaucratic/institutional knowledge, but add to that elevated prominence and authority as Fed Chair and she is likely to be extremely devoted to building consensus on the Committee. In practice some may see this move as her succumbing to pressure by other members, but if policy consensus can be reached to the point where there are fewer dissents on FOMC votes or in public speeches, Yellen could herald in an era of decreased uncertainty at the Fed.
The more direct mechanism by which Yellen will likely work to decrease policy uncertainty is through forward guidance. Yellen has made clear that she believes this type of central bank communication to be the forefront of policy. Last week I provided a more thorough evaluation of the institutional shift toward forward guidance, but with Yellen at the helm, this shift is likely to be even more pronounced.
As tapering shifts the Fed away from direct market intervention and we face a lag period between the end of tapering and the first steps to raise the Fed Funds Rate, it will be essential for the Fed to communicate their policy goals and timeframes more precisely than ever before. As Bloomberg News columnist Caroline Baum points out, thus far the Fed's version of open communication has been so market contingent that it is far from clear. Although Ms. Baum's assessment of consumer beliefs about inflation as opposed to Fed inflation targets are an illogical way of measuring market response to Fed communications, her assessment that inflation targets have done little to clarify the Fed's policy direction is absolutely correct. Moreover, this conclusion was predictable from the outset of the inflation targeting policy.
Setting aside inflation targeting, the more pressing question is how precisely the Yellen Fed will identify the timeline for tapering, and then how precisely it will identify a timeline for forward interest rate guidance. This is a delicate strategy because it can't make too many calendar based assertions without potentially undermining its own credibility if/when economic conditions necessitate a change in policy. However, it also can't be too vague or market uncertainty will prompt increased volatility and undermine the ongoing economic recovery. Yellen will likely walk this fine line through increased communication efforts since she herself has proclaimed that the FOMC has been already been using "…communication…as its primary monetary policy tool."
What, if any, effect will this communication effort have on markets and the broader economy? While the Fed's goal may be to reduce uncertainty and soothe markets to promote economic growth, unless the Fed can engage in a more structured communication effort or Fed watchers can find a more structured method for analyzing the constant barrage of Fed communications, the likely result will be continued uncertainty resulting in elevated volatility. In anticipation of this problem, I am presently working on a method to systematically examine these communications. Until that data is complete, market participants will have to follow traditional methods of central bank analysis and rely on the expected tapering timeline that indicates asset purchases will conclude in mid-2014 and has the economy on pace for an interest rate increase in early-to-mid 2015. However, this means interest rates are likely to rise ahead of the Fed Funds Rate hike in 2015, especially since the Fed is likely to taper off bond purchases faster than it tapers MBS purchases due to fears they will undermine the continuing rebound of the residential real estate market.
The bottom line is that in the near-term interest rates are likely to fall as those traders who feared a more hawkish Summers-led Fed are going to be relieved by a Yellen Fed. Although rates may be depressed ahead of the Fed's tapering announcement, once tapering begins rates are likely to gradually climb. If the Yellen Fed can effectively communicate, this climb will be smooth, but unclear communication will result in small spikes and drops along the path to higher rates.