Monetary Policies FED.png

Mr. Obama kicked off speculation about the Fed job in an interview with Charlie Rose in June in which he said Mr. Bernanke “had stayed a lot longer than he wanted or he was supposed to”. Mr. Bernanke’s second four-year term as Fed chairman expires Jan. 31. The very public disclosure of Mr. Bernanke’s plans led to an unusually public debate over potential successors.

While I am writing this article it is still undecided who will serve as Federal Reserve Chairman in the next term starting end of January 2014. Till a couple of weeks ago this uncertainty would have mattered more. The front-runner was a candidate, which would have meant a clear break with past: Lawrence Summers. But then he withdraw from the race and the current short list of most likely nominations, from Yellen to Kohn, from  Ferguson to a third Bernanke mandate, would bring a choice pretty much in line with recent Federal Reserve policy and behavior.

Why did Summers withdraw?

“I have reluctantly concluded that any possible confirmation process for me would be acrimonious and would not serve the interests of the Federal Reserve, the Administration, or ultimately, the interests of the nation’s ongoing economic recovery.”

This was the main passage of the letter Summers sent to Obama to withdraw his candidacy.

Mr. Summers, who was director of Mr. Obama’s National Economic Council early in his presidency, was widely believed to be the president’s first choice. But opposition from liberals and women’s groups and, importantly, from some Senate Banking Committee Democrats, had been mounting. For them, Mr. Summers became a symbol (a caricature, his admirers say) of all the failures of financial deregulation that led to the 2008 financial crisis. Critics seized on Mr. Summers’s reputation for abrasiveness, his closeness to Wall Street and accusations that he was hostile to women. Ezra Klein on the Washington Post summarizes well the situation: “Larry Summers’s campaign to replace Federal Reserve Chairman Ben Bernanke wasn’t doomed by any of the typical doubts about a potential Fed chief. Senate Democrats weren’t worried that Summers was too tolerant of inflation or insufficiently committed to quantitative easing. In fact, they weren’t worried about his opinions on monetary policy at all. Summers fell because at least five Democrats on the Senate Banking Committee doubted his bona fides as a bank regulator. But even that doesn’t get at the whole truth. Summers really fell because those Senate Democrats — and many other liberals — don’t trust the Obama administration’s entire approach to regulating Wall Street. For all the talk of Summers’ outsized personality and polarizing past, he really lost because he was a stand-in for Obama.”

For sure the confirmation process was going to be acrimonious and eventually unsuccessful. It is likely that Obama wanted to avoid wasting precious political capital in such a battle with two bigger ones going on at the same time: Syria and debt ceiling.

Odds now ?

After such a ‘coup de theatre’ we all know that another one is always possible. In this chart I built from the odds given by a betting agency the main take away is clear. There is a clear front runner (Yellen) and a clear lower probability alternative (Kohn).

The only possibility I can see outside this list is a surprising third term for Ben Bernanke which received a sonorous endorsement from Warren Buffet - “I think if you’ve got a .400 hitter in the lineup, you don’t take him out… I don’t have a second choice” – but nothing more.

Janet Yellen

Even before Summers entered the race, Yellen was seen as the easiest choice. She is steeped in the Fed culture, a culture that nobody can understand from the many perspectives that she has had. Yellen has spent most part of her career deepening her ties to the Fed’s regional presidents. As Fed vice chairman, Yellen’s attentiveness to the district Fed presidents proved invaluable in building consensus on policy issues. She took control of a subcommittee focused on the Fed’s communication challenges. For years, policy makers on the FOMC had been unable to agree to holding press conferences or spelling out goals for inflation and unemployment. At the end she managed to finalize a breakthrough in policy: a January 2012 statement that committed the central bank to achieving inflation of 2 percent in the longer term and spelled out a goal of 5.2 percent to 6 percent for the unemployment rate. The Fed’s regional presidents, eight of whom hold Ph.D. degrees in economics, agreed unanimously to adopt the statement. If this effort in enhancing communication is being successful is debatable (more on this topic later) but it witnesses good skills in building consensus. Her ability to persuade academics was honed at the University of California-Berkeley, where she was a professor from 1980 to 1994 before moving to Washington to serve as a Fed governor, and again from 1999 to 2004 before becoming president of the San Francisco Fed. By the way her record for consensus isn’t perfect. She is highly regarded by many central bank staff members, who call her an effective leader with a sharp mind. But she has clashed with others and left some hard feelings in the wake of those confrontations, according to interviews with more than a dozen current and former staff members and officials who worked with her directly in recent years. We could say that compared with the current chairman, Janet Yellen brings a demanding and harder-driving leadership style to the central bank, in contrast to Mr. Bernanke’s low-key and often understated approach.

But the real reason which could stop her candidacy has not to do with personality issues. Obama’s ideology stands quite opposed to what current Fed policy represents.  QE lifts prices of risk assets, making rich people richer; after all, the wealthiest people own the vast majority of risk assets.  At the same time, ZIRP (Zero Interest Rate Policy) acts as a wealth transfer from the poor to the rich. The president is outspoken about the growing wealth divide and income inequalities.  The last thing he wants to do is further exacerbate them and fuel benefits to the “millionaires, billionaires, fat cats, and jet-setters” but maybe after Summers failure he is left with no other solution than tolerate a Fed very similar to the current one.

FED Presidency.png

Donald Kohn

Don Kohn would be an ideal candidate and great compromise.  He spent his entire 40 year career in the Federal Reserve System.  He was well liked by Fed colleagues, politicians, and financial market contacts.  During his career, he wanted desperately to be the Fed Chairman. However, today he may not want to come out of retirement, especially for ‘this’ position.  The job now is materially different than in the past, due to rates being stuck at the zero lower bound for the fifth year in a row.  Furthermore, the job would begin during the peak in risks of the greatest monetary policy experiment in modern finance. Lastly, superstar - yet mortal - Don Kohn is 70 years old.

Whoever the chair plenty of challenges ahead

While we are waiting for a name, which may already be disclosed by the time you read this article, I think it is to be more interesting to concentrate on the many challenges lying ahead for the most important central bank in the world.


In the last few years the Fed has been trying to move towards more transparency. The main change has been to extend the information provided after FOMC. Starting April 2011 every other FOMC (basically on a quarterly basis since usual yearly calendar schedules 8 FOMC) brings not only a one-page communiqué (usually parsed word by word from markets) followed 3 weeks later by full minutes but a full menu: communiqué, SEP (Summary of Economic Projections) from all members of FOMC and a complete conference from the Chairman followed by extensive Q&E (BCE style). Another effort has been made in supplying a more explicit reaction function regarding future moves on interest rates, a push now called by everybody Forward Guidance. They started to  state for how long (“extended period of time”) or till when they intended to keep interest rates “exceptionally low” and later on began to give explicit conditions needed to start hiking. Currently we are told that unemployment rate has to descend below the 6.5% threshold for the Federal Reserve to start thinking about a hike.

Overall it seems a sensible effort. Someone is even asking to go further down this road. It is the case of Governor Jeremy Stein (still a potential runner, even if a very low probability one, for Bernanke replacement) which recently urged the Fed to adopt a “transparent and predictable” process for tapering that would reduce the monthly asset purchases by a “set amount for each further 10 basis point decline in the unemployment rate”. He said: “My personal preference would be to make future step-downs a completely deterministic function of a labor market indicator, such as the unemployment rate or cumulative payroll growth over some period. For example, one could cut monthly purchases by a set amount for each further 10 basis point decline in the unemployment rate.” “But I do think that, at this stage of the asset purchase program, there would be a great deal of merit in trying to find a way to make the link to observable data as mechanical as possible.”

But let’s see what happened at the last FOMC on September 18th with the ‘no tapering’ decision. While everybody was set-up for anything between 10 and 20 billion of reduction in the LSAP (Long Term Asset Purchase program, a.k.a. QE3) with no much dispersion around the median expectation, the Fed balked giving a clear example of how things can backfire: too much information and guidance ex-ante can easily generate more confusion than necessary when deviating just a little from the script.  Morgan Stanley commented like this after the FOMC rendering quite well a pretty common feeling among observers. “At this point we have no clarity on what might drive a decision to move forward with QE tapering at the October or subsequent FOMC meetings. … At this point who knows what that means specifically in terms of near-term incoming data looking ahead to the October 29-30 and December 17-18 FOMC meetings. We don’t have any good sense of what the Fed’s reaction function is at this point, so our initial baseline is flip a coin on QE tapering at upcoming meetings.”

Another example of how too many information can be confusing and, more importantly, so inconsistent to undermine long term credibility, was conveyed by the FOMC members projections on interest rates path and predictions of macroeconomic variable. The forecast for unemployment rate at the end of 2016 (for the first time produced at the last FOMC since before they stretched only to the end of 2015) is 5.65% (5.4%-5.9% range). For inflation is 1.95% (1.9%-2.0% range). We could call them condition of full employment with inflation at target, almost a perfect world. The Taylor Rule is a well know model to estimate short term interest rate equilibrium with inflation and output gap (unemployment rate could be a way to estimate the output gap). It has many versions and it is often cited in Fed’s research papers as a reference point. Well, any rough application of this model would point to a 4% for equilibrium short-term interest rate (2% for inflation + 2% real growth with small or no output gap). Maybe 3.5% using a more cautious approach like the Balanced Approach Taylor Rule, the favourite version of Janet Yellen. The median projection from FOMC members for Fed Funds at the end 2016 is 2% (according to the yield curve the market was quoting roughly 2.30%-2.35% before the FOMC and adapted quickly to the Fed ‘suggestion’ in few hours after the meeting).

A Goldman Sachs chart showing what Fed Funds suggested by the Taylor Rule compared with FOMC members projections (the’dots’).

Monetary Policy Fed Funds Rate.png

In the Q&A Bernanke has been (obviously) questioned on such an inconsistency. His reply has not been particularly convincing or precise: “the primary reason for that low value is that we expect that a number of factors—including the slow recovery of the housing sector, continued fiscal drag, perhaps continued effects from the financial crisis—may still prove to be headwinds to the recovery. And even though we can achieve full employment, doing so will be done by using rates lower than, sort of, the long-run normal. So, in other words, in economics terms, the equilibrium rate, the rate that achieves full employment, looks like it will be lower for a time because of these headwinds that will be slowing aggregate demand growth”. A convoluted answer which is almost an admission that they do not really believe growth will reach and stay around 3%, as from their projections, in the next three years, in my view. In fact the market, after a brief celebration (new historical highs for the US stock markets), seems to be following such a hint more than correcting the initial strength.


Trade-off between benefits and costs of keep growing Fed balance sheet has been undoubtedly worsening. I wrote extensively about it one year ago in the October 2012 edition, “Bernanke goes all-in: QE-infinity”. Risks of distorting markets, inflating an asset bubble, worsening the wealth divide and eventually creating too much inflation down the road are higher and higher for every billion of Treasuries or MBS bought while the positive effect on the real economy maybe there (we will never have the evidence of what would have happened without QE) but it is more and more difficult to single out.

However the men in charge, Bernanke with Yellen and Dudley next to him, are pretty convinced that any slowdown of the economy has to be helped out from more asset purchases. Part of it, often unsaid, is due to the terrible mess in Washington, particularly evident as I write. When the fiscal side cannot react then the monetary authority has to do all the lifting. Still they do not look scared from the potential consequences. And there are many FOMC members backing them. Listen here. Evans (Chicago Fed president) just said that “Fed unable to provide as much stimulus as it would like” and “Fed encouraging additional risk-taking”. Only three months ago actually Bernanke and Evans were telling us how the Fed was worried about “excess froth” in the market. But now more speakers are going the other way. Kocherlakota (Minneapolis Fed president) yesterday said he would be willing to create asset price bubbles in return for an improvement in the employment outlook.

On the other end a few voices keep saying, now louder, that QE brings risk without benefits. Fisher (Dallas) has been in this camp for long now. The argument raised by Fed hawks goes like this: the policy is doing little for the economy, but instead is pumping up asset bubbles anew. Also Richmond Fed President Lacker had been warning of this threat for some time, but it was Kansas City Fed President George’s dissent at her first meeting in January that really put the story on the front pages. Her view has been consistent all year, and was given additional credibility by the fact that her actual economic view has been soft. She’s a QE dissident not because it isn’t necessary, but because it hasn’t worked and the Fed is courting unintended consequences by pursuing further QE. Recent Lacker’s comments fill that out arguing against additional QE and also suggesting that US GDP might be no better than 2% for a considerable time to come.

The voting members of FOMC are 11. The Chairman, the NY Fed president, 4 of the other 12 regional Feds with a yearly rotation, 5 Governors nominated by the President and the Congress. The 2014 rotation will bring two hawks (Fisher and Plosser) in exchange for one (Esther George). Not a lot. But remember also that the most convincing dove, Ben Bernanke, should be gone soon.

The QE trap

BOE ‘s Mervyn King stated in January 2012: “I have absolutely no doubt that when the time comes for us to reduce the size of the balance sheet that we’ll find that a whole lot easier than we did when expanding it…”.

It sounds like a joke but it is not. It is just bluntly wrong as the Fed is already finding out. This is going to be the biggest challenge of all.

One hypothesis on how this perilous exit is going to unravel has been very well described recently by one of my favourite economists, Richard Koo. The inventor of the “balance-sheet recession” now enlightens us on the miseries the Fed has to face: the ‘QE-trap’.

After the no-tapering announcement US rates have been falling back but giving back only a small portion of the rise started with famous Bernanke’s speech in front of the Joint Economic Committee of the Congress on May 22nd, where the ‘tapering’ concept was born. Starting to speak about and performing tapering will generate a new leg higher, likely above previous highs. Koo: “I worry that this kind of intermittent increase in rates threatens the recoveries in interest rate-sensitive sectors such as housing and automobiles. That could lead to renewed hesitance at the Fed and prompt it to temporarily shelve or postpone tapering. While rates might then decline, reassuring the markets for a few months, talk of tapering would probably re-emerge as soon as the data showed some improvements, pushing rates higher and serving as a brake on the recovery. Then the Fed would again be forced to delay or cancel tapering. In my view, recent events have greatly increased the likelihood of this kind of ’on again, off again’ scenario, something I warned about in my last report. To be honest, I did not expect it to occur so soon.”

It is a vicious cycle where, as soon as the economy picks up a bit, the authorities begin to talk about tapering, which sends long-term rates sharply higher and slacken recovery and inflation, effectively preventing them from winding down the policy. In this kind of world the economy never fully recovers because businesses and households live in constant fear of a sharp rise in long-term rates.

Good luck to the new Chairman/Chairwoman.

Alessandro Balsotti