On Monday Janet L. Yellen, currently Vice Chairman of the Federal Reserve gave a speech laying out the case for the Fed’s current policies. Ms. Yellen is commonly viewed as one of the strongest supporters for taking action to reduce the current unemployment rate. She is also one of the likely successors to Chairman Bernanke when his term expires. Her views are important.
Ms. Yellen did a compelling job of laying out the costs of the recent recession to workers and homeowners. But is should not really come as a surprise that many people suffered over the last few years. The real issue is whether the Fed’s current policy of trying to lower interest rates by purchasing assets is good for the country. On this important question she had surprisingly little to say. She did cite a prior speech by Ben Bernanke which in turn cites studies showing that the unprecedented purchases have lowered interest rates, but this again should hardly be surprising. When the Fed is buying roughly $80 billion in new assets every month you would expect that. The real questions are whether its policies are jeopardizing our long-term future for a little extra growth now.
The answer to that question depends on a couple of things. One is the impact that government policy can have at this particular time. Ms. Yellen includes a couple of graphs that show that fiscal policy and job growth have been disappointing during the current recovery, but the slides comparing both to past recessions only start at the beginning of each recession. It would have been interesting to see what the comparisons looked like in the year or two prior to each recession. The Fed seems to believe that the Great Recession was pretty much like its predecessors and therefore the recovery and room for fiscal stimulus should also have been roughly the same. An alternative view is that this time was different. If unemployment was artificially low before the recession, then it should not be a surprise that it has fallen more sharply and recovered more slowly than in the past. If government deficits were larger, then the scope for fiscal stimulus at reasonable deficit levels is also constrained. Finally, if much of the activity and wealth creation prior to 2007 was artificial and never backed by true economic value, then we would not expect the declines in GDP and household wealth to recover their old values. But Ms. Yellen never addresses these issues.
The Fed’s strategy is to lower real interest rates. This will have three effects. First, it should make it cheaper for consumers and businesses to borrow. Second, by boosting asset values it should make them richer and therefore more inclined to spend. Third, it lowers the income of savers and pension funds. If our long-term problem is a surplus in spending and low savings rates or, to put it another way, too much consumption and not enough investment, then it is not clear that the Fed’s policy is wise. Similarly, if the rise in asset values is temporary and artificial, then the Fed’s wisdom is also questionable. Again, there is no discussion of this. The Fed’s assumption seems to be that we simply need to jump start the economy and then it will take off on its own momentum. But other researchers, notably Carmen Reinhart and Ken Rogoff, have argued that, because this was a financial recession the recovery will be longer and less responsive to stimulus.
A second criteria for judging Fed policy is whether it harms the future. It is certainly hard to argue that inflation is a problem. Not only is current inflation low, there are few signs that people expect higher inflation in the future. But the real test will come when the economy begins to grow rapidly and the Fed has to raise interest rates and unwind its position. Just as buying assets lowered interest rates, not buying them will raise them. The recent history of the Fed is that it has been slow to raise rates when economic growth resumes. In its defense, any rate increases are always met with political opposition because they slow growth from what it might otherwise have been. In such a circumstance, inflation expectations may rise. In fact, Ms. Yellen’s speech invites such a conclusion when she makes it clear that a rise in inflation expectations would not necessarily cause the Fed to pull back if unemployment was still high. It is clear that future stores of wealth such as private savings, pension plans, and college endowments will all be lower because of the current policies.
The lack of serious public discussions of these problems gives one the impression that the Fed is winging it: pursuing unprecedented increases in its balance sheet largely because it feels pressure to do something and worrying about the consequences later. Such strategies often turn out poorly.