Janet Yellen Considers Her Last Act

Janet Yellen will be replaced by Jerome Powell as head of the United States Federal Reserve when her term ends in February 2018. Nonetheless, most observers believe that she has done a good job as Fed chairperson. She inherited a very loose monetary stance from her predecessor, Ben Bernanke, and started to apply the brakes to a very dangerous machine as soon as the U.S. real economy began to recover in terms of employment and growth. She has held a steady course. The American economy is now expanding at a decent speed (a year-to year-rate of 2.3 percent), unemployment is at 4.4 percent, and the ghost of deflation has receded (annual inflation is now running at about 2.2 percent).

Feeling good

Moreover, plenty of Americans are happy, since consumers have been financing and refinancing their purchases at real interest rates close to zero. The same applies to participants in the real-estate market, while the Treasury and large corporations have borrowed lavishly at low cost. Retired people and investors have also had reason to celebrate during the Yellen years. While bonds have paid disappointingly low interest, stock prices have surged, bringing substantial capital gains that more than offset those lean yields.

Risky countries have benefitted from years of easy money in the U.S. (and in Europe), too. Several shaky borrowers have managed to find investors looking for a quick return on high-yield bonds. It has been a time when lenders forgot about risk and enjoyed a good return, while borrowers filled up their tanks and kicked the can down the road.

The Fed’s masterstroke (or good luck) was that all this injected liquidity ended up on the stock exchange, rather than in expenditure. That made investors (including retired people) happy, while averting a surge in inflation that could have played havoc with the structure of relative prices.

We have not reached the end of the story, however. In the next few weeks, Ms. Yellen will be facing her final challenge at the Fed. Her task is to neutralize the profligacy of the past before inflation breaks out and the stock exchange adjusts. She must also minimize the impact of higher interest rates on the beneficiaries of the easy-money bonanza.

Light touch

Will she succeed? A key development deserves close attention. Until recently, financial markets expected a drastic – rather than a soft – change in the Fed’s monetary stance. This “hard landing” would have involved a relatively sharp rise in interest rates, troubles in some developing countries, and a hard-to-predict response by the real economy. Private consumption, real estate prices, and investments in fixed capital (machinery) could have all behaved like a roller coaster.

Nothing of the sort happened, because the Fed opted for a super-soft approach. Ten-year Treasury yields today are roughly where they were three months ago. Rather than executing a U-turn and absorbing liquidity, the U.S. central bank decided to reduce the amount of additional liquidity it would inject and announced that it would start drying up only in 2018, if not later. Markets were relieved.

Investors have kept buying stocks despite overblown prices, household spending has held up nicely, and bad borrowers have continued to find plenty of creditors in search of high returns. Even a few months ago, this kind of a soft landing sounded rather unlikely. Now, the picture is more promising.

Yet this encouraging scenario is heavily dependent on expectations and growth. These are at risk, because the Fed has resolved to stop handing out gifts of easy credit and cheap mortgages to a large share of the U.S. population. It has also decided to forget about the capital gains Americans received during almost a decade of monetary profligacy.

No uncertainty

For now, the gamble seems to be paying off. Ordinary Americans seem content. They believe the economy is off to a good start and look forward to experiencing fast – and possibly accelerating – growth over the next few years. This sanguine mood is strengthened by what is happening in the entire OECD area (including Europe, where annual growth is 2.3 percent) and beyond (e.g. China, whose economy is growing at a rate of close to 7 percent).

Under this optimistic scenario, the Fed seems to believe that the imbalances inherited from the past can be neutralized gradually. Excess liquidity can be mopped up by the greater demand for money generated by larger incomes, and overblown levels of public indebtedness will appear less threatening as the debt-to-GDP ratios recede and governments become less vulnerable to sudden increases in debt-service costs.

One could argue that the Fed’s prudent policy aims to ensure that no uncertainty creeps in, and that the possibility of future roller coasters remains off the radar. Ms. Yellen and her colleagues are following expectations, but at a distance: when markets believe that liquidity should be restrained (with moderation), the Fed gets the message.

Market operators, trusting that their message will not be ignored, factor in the monetary policy moves that are expected to follow. So far, the Fed has not disappointed them. The world of money and finance expected slowly rising interest rates at least until mid-2018, and that is what they got. Should a negative shock occur, the Fed would be expected to pause or reverse course, and the consequences of the shock would be partially offset by easier money.

Keep smiling

In this light, U.S. monetary policy hinges on whether the present momentum can be sustained. If global growth rates stay above 3 percent and growth in the developed Western economies is above 2 percent, a soft-landing scenario is indeed realistic: expectations will include a moderate rise in interest rates and the monetary authorities will oblige. But this kind of economic performance cannot be taken for granted.

In particular, labor productivity gains are far from impressive. Over the past three years, productivity growth in the U.S. has averaged 0.48 percent, well behind that well-known straggler, the euro area (0.71 percent). To provide a longer-term comparison, one might look at the 1970-1990 period, when U.S. and German productivity growth averaged 1.53 percent and 3.05 percent, respectively.

Unless productivity picks up, economic growth in the Western world is going to sputter. Perhaps the reason why today’s most prominent central bankers – Janet Yellen at the Fed and Mario Draghi at the European Central Bank – are still smiling is because they want to keep investors quiet. For the same reason, Ms. Yellen and Mr. Draghi might hesitate about taking vigorous action to neutralize monetary liquidity because they know that today’s optimism has fragile foundations. It is better to stay cautious and steer a steady course, rather than assume an aggressive stance and then be forced to tack when the wind shifts and the sea gets rough again.

From the monetary viewpoint, therefore, there is no reason to expect rigor in the near future. The situation differs slightly depending on which side of the Atlantic one considers. Even so, Western central bankers are behaving as if they did not believe in long-term growth and are bracing for a change in sentiment.

One may doubt whether monetary profligacy is justified by slow growth. Unless productivity gains accelerate relatively soon, however, today’s economic performance in the U.S. and parts of Western Europe will soon be only a fond memory. One consolation is that central bankers will not be blamed for having nipped recovery in the bud.

Enrico Colombatto is Professor of Economics at the University of Turin and Director of Research at the Institut de Recherches Economiques et Fiscales (IREF).


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