Circumstances around Yellen's departure akin to Greenspan's

Circumstances around Yellen's departure akin to Greenspan's
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Janet YellenJanet Louise YellenClinton to be honored at Harvard for ‘transformative impact’ Fed nominees vow to rebuff pressure from Trump on interest rates Fed official defends moves on bank regulation, supervision MORE’s tenure as Federal Reserve Chair ended Friday, and Jay Powell was sworn in as Fed Chairman Monday. Powell’s first day will long be remembered as the day when the stock market plunged by over 4 percent, throwing a scare into investors.

This should certainly serve as a wake-up call at a time when the economy and financial markets seemed to be on cruise control.

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It also provides a little different tone to the narrative of Yellen’s time as Fed chair. Yellen presided over four years during which the economy improved and asset prices appreciated sharply.

 

As a result, she has been widely praised as successfully navigating the economy through potentially rough waters as the Fed finally began to normalize monetary policy after seven years of zero rates and several rounds of asset purchases.

However, it is far too soon to render a verdict or put a grade on Yellen’s tenure. Of course, the Federal Reserve can go a long way toward ensuring a favorable economic environment for a while simply by running an extremely easy monetary policy for an extended period.

The chickens will eventually come home to roost, but it often takes years for them to complete the journey. In Yellen’s case, it remains to be seen whether she did a good job as Fed chair or not.

If the economy continues to post decent growth going forward but fails to overheat (i.e., inflation never accelerates much), then it can safely be said that Yellen’s strategy — maintaining zero rates for so long, waiting until 2017 to finally begin to raise rates in earnest, all the while keeping the Fed’s balance sheet at $4.5 trillion until the fall of 2017 — turned out fine.

However, there is much that could go wrong. First, the economy and in particular the labor market could overheat. For years, as the unemployment rate was falling faster than anticipated, Yellen and her colleagues highlighted hitherto obscure indicators to suggest that there was really more slack than the more familiar metrics suggested.

As she leaves the Fed, the unemployment rate is running at a 17-year low and could well push down to a 50-year low within the next year to 18 months (given the lags in how monetary policy operates, that is the case pretty much regardless of what the Fed does from here).

Second, though inflation has been stubbornly low, there are signs that both wage and price inflation may be perking up. In a year’s time, it is entirely possible that inflation will have blown through the Fed’s 2-percent target while policy is still far below traditional measures of “normal” (as determined by policy rules such as the Taylor Rule).

Third, and perhaps most importantly, as recent events underscore, the Fed has pumped massive liquidity into the financial system for years, barely tempering the stance that was taken in the midst of the financial crisis.

As seen in the last two business cycles, the greatest risk to the modern economy when the Fed is too easy for too long is a buildup of asset bubbles, which can lead to disruptive asset price collapses when they finally burst.

Fed officials insist that current asset prices are nowhere near high enough to constitute a bubble, but these things are not easily determined until well after the fact. The market action since Friday is a mere whiff of what that scenario may look like.

Interestingly, as Yellen exits, the circumstances at the time of her departure are remarkably similar to Alan Greenspan’s retirement. Greenspan left the Fed in early 2006, at which time the Fed was nearing the tail end of a long series of “measured” rate hikes after the Fed had left very low rates in place for several years.

The Fed was arguably late to get started and too slow to boost rates back to a relatively balanced setting. When he left, everything seemed great. The economy was surging (2004 and 2005 are still the last years when real GDP growth exceeded 3 percent), the unemployment rate had fallen well below 5 percent, and asset prices were riding high.

In fact, just before his retirement, a former colleague at the Fed dubbed Greenspan “the greatest central banker who ever lived.” Unfortunately, it turns out that monetary policy had been far too easy for several years in the 2000s, feeding a massive bubble in home prices and excessive leverage in the financial system.

Greenspan’s reputation took a massive hit when the financial system unraveled in 2007 and 2008.

Hopefully, the Powell Fed will avoid the sort of trouble that befell the economy and financial system in 2008. The point here is not to suggest that history inevitably repeats itself.

Rather, the message is that it is far too soon to write the book on Janet Yellen’s legacy as Fed chair. Check back in four or five years to see if this story has a happy ending.

Stephen Stanley is the chief economist for Amherst Pierpont Securities, a broker-dealer providing institutional and middle-market clients with access to fixed-income products.