The Yellen era will feature more of the same: the same monetary policy and the same unanswered questions.
Appointed today as Ben Bernanke’s successor as Fed chief, Janet Yellen is likely to pursue a similar approach to monetary policy. That makes any taper in bond buying likely to be later and gentler, a factor which will support, all things being equal, riskier assets.
Less clear, and also unchanged, is how she and her highly divided colleagues at the Fed will react as yet another year of unsatisfactory growth and low inflation call into question the wisdom of the whole approach.
What this means is that riskier assets like equities will probably do better in the short term under Yellen than under the alternative choices, notably Larry Summers, who withdrew from consideration last month. That ‘better’ performance, however, comes at the price of some serious embedded risks.
First, let’s look at the just-released Fed minutes from the September meeting, at which they took the decision to delay the taper amid what looks from the outside like much disagreement and unease.
All of this misallocation of capital is not cheap, and we will all pay in the end through lower growth, more volatility and lower returns.
Fed officials in favor of holding off on tapering feared how well the economy could withstand less bond buying, and the tighter conditions tapering implies.
“The announcement of a reduction in asset purchases at this meeting might trigger an additional, unwarranted tightening of financial conditions, perhaps because markets would read such an announcement as signaling the Committee’s willingness, notwithstanding mixed recent data, to take an initial step toward exit from its highly accommodative policy,” the minutes said.
The opposing view: that delaying would undermine the central bank’s credibility and make it only more difficult to climb down from the position later.
Sadly, both arguments are, if anything, now more true than in September.
The budget impasse, especially the possibility that the U.S. may shortly default on its debt, leaves the doves with more reason to believe that higher interest rates – which is what tapering means for us in the real world – don’t make sense.
And Yellen will, as the hawks clearly fear, be in a position where she must guide a market with less faith in her institution’s transparency and in its commitment to so-called forward guidance, a fancy monetary policy term for convincing people that you will or won’t do something far in the future.
Divisions multiply
Remember too that when we say Yellen embodies continuity, what we really mean is that unlike Summers she hasn’t got a track record of over-confidence breeding major errors. She is human, however, and though superbly qualified, may well diverge in time from Bernanke’s policy path.
Indeed that Bernanke himself was close to leading the consensus of the FOMC to tapering is evidence that he may well have become more hawkish and less asset-inflation-friendly had he taken a third term.
The Fed is highly divided, and with good reason.
Those arguing against tapering see, rightly, an economy with low participation in the workforce, poor job creation and below-target inflation.
Those arguing for the taper see, rightly, the risk of bubbles and the mounting problem of how to get out.
But as QE ages, and as we continue to see little evidence that it does much beyond encouraging asset price inflation, capital misallocation and increasing economic inequality, expect more pressure and more divisions.
To be sure, the current morass in Washington may, ironically, cause the Fed to close ranks behind continued QE. I have little doubt the Fed will respond forcefully to a default and to the financial market dislocation that would ensue.
Should a default happen, not only won’t tapering happen, but the Fed will do its best to provide additional stimulus.
That’s both right and proper and a real shame. Right and proper because a default would deal a real blow to the economy and would dislocate markets in a way which only a central bank can handle. A shame because it would extend what is looking like a failed experiment in monetary policy, and because it would reinforce the Fed’s role as provider of insurance against dumb behavior.
For investors, the advent of the Yellen Fed highlights two conflicting truths.
First, investors ought probably to take on more risk, or rather keep their portfolios relatively aggressive. The Fed is paying you to take risk, and so long as the debt debacle doesn’t lead to fundamental doubts about U.S. creditworthiness, these are payments it is good for.
Second, investors probably ought to be less optimistic about long-term returns. All of this misallocation of capital is not cheap, and we will all pay in the end through lower growth, more volatility and lower returns.
Sounds a bit like the last 15 years, doesn’t it?
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)