Update 248: Yellen Years at the Fed
All’s Well and it Ends with Wells
With markets calmer now following a correction that gave back all of this January’s paper gains in three early-February trading sessions, we can take a longer-term look at a key transition in Washington crowded out by correction coverage.
Janet Yellen concluded her term as Federal Reserve Board Chair last week. During her four years in charge, the unemployment rate shrunk from 6.7 percent to 4.1 percent and the economy has sustained one of the longest-running recoveries and consecutive months of growth in the nation’s history. A retrospective on the Yellen years and what lies ahead at the Fed follows.
The Yellen Consensus
The Yellen consensus is her careful consensus building approach that led to many unanimous decisions. During her tenure, Yellen averaged 0.71 dissents per meeting. For reference, former chair Volcker averaged around 1.23 dissents per meeting. Powell takes over that consensus building approach and is not looking to bring about earth shattering change in either regulatory or monetary policy arenas.
Source: Thornton and Wheelock (2014)
The intricate and high-stakes business of interpreting economic data and deciding collectively on monetary policy is a critical consensus building task at which Yellen excelled. Studying at the elbow of her predecessor Ben Bernanke, she maintained the consensus and policy course he designed to help with economic recovery from crisis.
As a result, Yellen was able to set the Board on a remarkably smooth path to normalization, beginning with a complex and historically unprecedented two-fold process:
- Interest Rates: Gradually increase the near-zero federal funds rate
- Balance Sheet: Begin reducing the Fed’s $4.5 trillion balance sheet holdings
In 2014, Janet Yellen inherited a federal funds rate that had been under 0.25 percent since 2009. In late 2015, the Fed increased the federal funds rate to a range between 0.25 percent and 0.50 percent. Since early 2017, the federal funds rate was increased four times, and today it ranges between 1.25 and 1.50 percent. The Fed under Chair Powell will have to determine whether to execute the plan to increase rates three times in 2018 and aim to finish the year with a federal funds rate at 2.00-2.25 percent. Many view three percent as the “normal” federal funds rate.
Balance Sheet Normalization
In 2014, Yellen inherited a sizeable $4.5 trillion Federal Reserve balance sheet. Over the previous six years, the Fed bought bonds to depress long-term borrowing rates. Last October, Yellen initiated a process to sell off the Fed’s holdings. Chair Powell expects the balance sheet to shrink to a total ranging from $2.4 to $2.9 trillion by 2022.
The Road from Here
- Fiscal/Monetary Policy Crosscurrents
One of the first challenges that the post-Yellen Fed will have to contend with is the massive, deficit-financed fiscal expenditures emanating from the Trump administration and the Republican-controlled Congress. As a body that is focused on monetary policy, the Fed won’t have a say in the fiscal stimulus envisioned by the White House and enacted by Congress, but it will certainly have to deal with the consequences.
The Tax Cuts and Jobs Act will add at least $1.5 trillion in new debt over the next decade, and the President has suggested hundreds of billions more, at least. Adding trillions in additional debt to the economy will have consequences that Powell and his fellow Governors will have to monitor closely.
While concerns about rampant inflation are misplaced, (the Fed has been primarily concerned with deflationary pressures for almost a decade), new deficits certainly run the risk of driving interest rates up more quickly than Powell would prefer. Economists estimate that a one percent increase in the deficit-to-GDP ratio translates to a roughly 25 basis point increase in long term interest rates. This could lead to a collision between DC and bond markets in New York and Chicago.
As we’ve seen over the past couple of days, markets are increasingly nervous about how the Fed might react to fiscal stimulus. All this will surely influence the Fed’s decision making about interest rate normalization and might well alter the schedule of rate increases. If all of a sudden there is no such thing as a bad deficit, the Fed — and the markets — will surely take notice.
- Regulatory/Supervisory Policy
The Fed is commonly described as having a “dual mandate” relating to employment and inflation. However, the Fed has another task: regulating banks. While the new chairman will carefully consider the scheduled interest rate hikes mentioned above, the Fed has a few other regulatory levers at its disposal that many, especially in the administration, would like to see tinkered with.
A key player in the conversation of regulatory oversight at the Fed is recently appointed vice-chair Randal Quarles. Where Powell voted in favor of every major post-crisis regulation and is seen as being cut from the same cloth as Yellen, Quarles is a far more conservative, small-government, regulator. He will be pushing an agenda of deregulating Wall Street starting with some of the protections put in place under the Dodd Frank Act that are up for negotiation.
Quarles’ deregulatory instincts mesh perfectly with a troubling bill working its way through the Senate now, S.2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act. The bill takes aim at four pillars of Dodd Frank: the SIFI threshold, stress testing, living wills, and the Liquidity Coverage Ratio (LCR). The Fed is currently considering reducing the LCR, which compels large banks to keep a certain level of highly liquid assets on hand to protect against any large market shocks. This, along with the constant pressure to de-list SIFI’s and defang the Volcker Rule, will be the most important threats to Obama-era systemic risk protections from the Fed.
- Yellen’s Last Act
Janet Yellen’s final act as Chair of the Federal Reserve was to dole out unprecedented enforcement actions to Wells Fargo & Co. on Friday. The Fed voted 3-0 that Wells Fargo would replace four board members in 2018, along with an enforcement action targeted at limiting the growth of the nation’s third largest bank. In taking these actions, the Fed signaled to big banks that when they fail to manage risk, both managers and boards will be held accountable.
The enforcement action taken bars Wells Fargo from growing beyond $1.95 trillion in assets — it’s reported size at the end of 2017 — unless given permission from regulators. “The Fed just put the fear of God into bank boardrooms across the country,” Ian Katz, an analyst at Capital Alpha Partners, wrote in a note on Sunday. “And that’s exactly what it wants to do.”
Yellen has been discussing taking enforcement action against Wells Fargo, whose massive fake account scandal hurt consumers and enraged progressives in Congress. The unanimous vote closed out the Yellen era with a bang.
Future of the Yellen Consensus
This action is likely to renew Congressional interest in the Wells Fargo matter, especially if Democrats win the House and Ranking Member Waters (D-CA) takes the House Financial Services Committee gavel. The action was one of the most unprecedented moves in the Fed’s history, and watch for Powell – who sees eye to eye with Yellen on so many issues – to uphold this action.
Yellen leaves the Fed in close consensus on rates, normalization, Dodd-Frank, and other regulatory issues. The Yellen years were years of stable recovery that served the country well. We owe Yellen and the Board a debt of gratitude, and we wish Chair Powell the best — by which we mean, “more of the same please.”
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