Dial down your expectations. Yes, Janet Yellen is about to be grilled by members of the Senate Banking Committee, who will rule on whether they find her to be a suitable successor to Ben Bernanke as head of the Federal Reserve Board. But that doesn’t mean that she’s going to be letting slip a lot of market-moving information of the kind that stock and bond investors are desperate to obtain.
Yellen’s interrogators will want answers to these questions, too. The 800-pound pink elephant in the room will be the size of the Fed’s balance sheet, which has exploded by $1 trillion in the last year or so. How much longer can the Fed’s monthly injections of $85 billion a month in support for the bond market continue, in light of numbers like that?
Yellen, in order to win confirmation and retain the maximum flexibility in terms of setting policy, isn’t likely to allow herself to be pinned down to a specific course of action on this or any other question, in spite of what is likely to be some tough questioning. Still, market participants will be parsing every careful choice of wording, every pause and even every facial expression.
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Even if Yellen avoids making a direct comment on any of the major issues below, be prepared for market pundits to read a lot in between the lines and speculate about what remains unsaid. Because, as this list of key questions for Yellen shows, rarely has a Fed chair taken on the job at a more critical juncture for the country’s economy.
1. When will the economy be ready for the Fed to step back? Yellen is seen as more of a “gradualist” than Bernanke, meaning that she may be slower to act when it comes to tapering off the monthly asset purchases known as QE3. Bernanke and his colleagues surprised investors by passing up the chance to begin tapering in September, and the Fed’s communication regarding the taper has been widely criticized. Members of Congress and many market-watchers will be listening for more details about the economic criteria the Fed is using to set the timing of its tapering. With interest rates already rising again, Yellen may also have to address the fundamental question of whether the Fed can reduce its stimulus without sapping economic momentum and prompting another cycle of bond buying. At what point will the Fed believe it can remove its crutches and let the economy run on its own?
2. How will the Fed unwind its balance sheet? Almost as important as the timing of any “taper” is how the Fed will deal with the massive bulge that these successive rounds of “quantitative easing” have created on its balance sheet. The taper is the tip of the iceberg: a bigger long-term issue (and one the market is very nervous about) is how Yellen will approach tackling this, from the “messaging” right through to execution. Let’s hope the Senate panel grills her on this question and isn’t satisfied with a general and non-committal response. Of course, the specifics will depend on the circumstances, but Yellen needs to demonstrate that she is already thinking hard about this topic if she is to win the confidence of investors.
3. What about inflation? After all, monitoring inflation is one of the Fed’s key tasks, even if it has taken a back seat to other priorities over the last five or six years, thanks to the financial crisis. The question may seem academic right now, but this much monetary stimulus, in the eyes of many economists, at least increases the risk that we’ll see a spike in inflation down the road. Moreover, while the Fed’s long-term inflation goal remains at around 2 percent, Yellen has indicated that she’d be comfortable with a modestly higher rate rather than trying to cope with the fallout from higher long-term unemployment.
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The Federal Open Market Committee is scheduled to meet next in mid-December, by which point Yellen almost certainly will have won approval from the full Senate to succeed Bernanke, thanks in part to some careful lobbying and preparation on the part of the Obama administration. Odds are that between now and the end of the year, this will result in some more market turbulence. The magnitude of the Fed’s support for the bond market, the astonishingly low levels at which interest rates languish and the prospect that the Fed has unintentionally created a massive credit market bubble mean that even a casual aside on Yellen’s part could send asset prices gyrating.
4. What will Yellen do to make sure the Fed is a strong, independent regulator? Some observers are pushing for Yellen to take a more independent stance vis a vis the Treasury Department. In the midst of the financial crisis of 2007 and 2008, the line between them blurred as both worked frantically to contain the systemic threat to the financial system and keep the economy afloat.
To remain a credible regulatory force, the Fed under Yellen will need to send strong signals that it is independent from the administration, both as a regulator and as a monetary policy-making entity. The same question hovers over the relationship between the Fed and the big banks it oversees, with some critics charging that the Fed has been too cozy. In practice, they say, that has meant stress tests that have been designed to be so easy that they’re impossible to fail.
Similarly, critics of the Fed will be looking for any insight that Yellen will forge ahead with implementing the provisions of Dodd-Frank – as well as for any opinions she can be provoked into offering about its merits and/or shortcomings.
It would be lovely to get some clear, concise answers to some of these questions – coupled with an equally coherent strategic plan to address policy conundrums – but since I haven’t spotted any flying pigs of late, I think I’m safe in suggesting we’ll be stuck with speculating until we’ve witnessed a few months of the Fed in action under the leadership of its new chair.
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