Thoughts from the Frontline:What Would Yellen Do?

The US Senate Banking Committee will hold hearings on Thursday, November 14, on the nomination of Janet Yellen for Federal Reserve chair. There will be the usual softball questions, for example, “Do you think high unemployment is a problem in the United States and if so what do you intend to do about it?” (which allows a senator to express his concern over unemployment and for the nominee to agree that it’s a problem). Or the always popular question, “What is the basis under which you would continue to hold interest rates at their current low level?” – as if she would answer anything other than, “Any future policy decision is of course data-dependent” or some variation on that response. Boring.

There have been a flurry of new research papers this week by Federal Reserve economists, IMF economists, and even Paul Krugman, all suggesting various policy responses going forward, but none suggesting a return to normal any time soon. I would be far more interested in getting a response from Yellen to some of that research, but even the questions raised in those papers don’t get to the real heart of the matter. So today, let’s pretend we are prepping our favorite Banking Committee senator (members here) for his or her few questions. What would you like to know? In this week’s letter I offer a few questions of my own.

First a brief caveat. Each of the questions below deserves multiple pages of background. I get that. There is only so much I can write in one letter. Further, some of the questions are intended to provide an insight into Yellen’s thinking and what research she considers to be relevant. Those are more the “inquiring minds wants to know” type of question. And since Senator Rand Paul is not on the committee, I have omitted some of the questions he might ask. Not that they aren’t interesting and shouldn’t be asked, but there is only so much space.

What Questions Would You Ask Janet Yellen?

Secondly, I know for a fact that a few Senators on this committee and even more of their staff members read my letter from time to time. I would expect that to be the case this week. I also know that I have some of the smartest and most thoughtful readers of any writer I know. If you want to address a committee staffer about questions you think your senator should be asking Janet Yellen, the comments section at the end of this letter would be an appropriate place to do so. Your comments will get read. Be polite, offer links to supporting documents, and have fun. I’m sure I’ve missed several important questions, including ones you’ll think I should have listed, so this is your opportunity to get them in front of the right people. Whether they will get asked is a different matter entirely, of course.

Finally, I am assuming that Yellen will be confirmed. While I would favor a Fed chair with a different economic philosophy, that is not going to happen. So rather than fantasizing about what is not going to happen, let’s think about what we would like to actually learn.

The Fed’s Dilemma

Conveniently, Ray Dalio and his team at Bridgewater penned an essay this week highlighting the Fed’s dilemma. I offer a few key paragraphs and a chart or two as a setup to my list of questions. Turning right to their very prescient comments:

In the old days central banks moved interest rates to run monetary policy. By watching the flows, we could see how lowering interest rates stimulated the economy by 1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

All that changed when interest rates hit 0%; “printing money” (QE) replaced interest-rate changes. Because central banks can only buy financial assets, quantitative easing drove up the prices of financial assets and did not have as broad of an effect on the economy. The Fed’s ability to stimulate the economy became increasingly reliant on those who experience the increased wealth trickling it down to spending and incomes, which happened in decreasing degrees (for logical reasons, given who owned the assets and their decreasing marginal propensities to consume). As shown in the charts below, the marginal effects of wealth increases on economic activity have been declining significantly. The Fed’s dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing. If it were targeting asset prices, it would tighten monetary policy to curtail the emerging bubble, whereas if it were targeting economic conditions, it would have a slight easing bias. In other words, 1) the Fed is faced with a difficult choice, and 2) it is losing its effectiveness.”

(In the following charts HH stands for “Household.”)

We expect this limit to worsen. As the Fed pushes asset prices higher and prospective asset returns lower, and cash yields can’t decline, the spread between the prospective returns of risky assets and those of safe assets (i.e. risk premia) will shrink at the same time as the riskiness of risky assets will not decline, changing the reward-to-risk ratio in a way that will make it more difficult to push asset prices higher and create a wealth effect. Said differently, at higher prices and lower expected returns the compensation for taking risk will be too small to get investors to bid prices up and drive prospective returns down further. If that were to happen, it would become difficult for the Fed to produce much more of a wealth effect. If that were the case at the same time as the trickling down of the wealth effect to spending continues to diminish, which seems likely, the Fed’s power to affect the economy would be greatly reduced.

What Would Yellen Do?

With that as a setup, let’s turn to our hypothetical hearing.

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