Tuesday, March 23, 2010

Is Janet Yellen the Best Candidate for Vice Chair of the Fed?

San Francisco Federal Reserve Bank President Janet Yellin is Obama's nominee for Vice Chair of the Federal Reserve Bank.  Why this policy dove may be a perfect short term answer, and a long term disaster.
The primary role of the Fed is the pursuit of maximum employment and price stability.  Sounds simple.
It's anything but.
I.  Maximum Employment
To pursue the goal of full employment, the Fed must make business conditions favorable to hiring.  That means that businesses must be able to borrow easily, expand and hire employees to facilitate such growth.  As you know, banks must keep a certain amount of their deposits with their local branch of the Federal Reserve Bank in order to have sufficient liquidity to prevent panics that contributed to the Great Depression.  When short term interest rates are low, banks can more freely lend to businesses because they don't have to keep as close an eye on their cash reserves.  Money's cheap.
When rates rise, banks keep a tighter rein on lending by strengthening borrowing standards.  It's harder to get a loan, business expansion slows and jobs are harder to get.
Why not have a continuing policy of low interest rates?
II.  Price Stability
Price stability is another way of saying low inflation.  Inflation is the amount prices go up every year.  Anyone who lived through the 1970s remembers that prices rose much faster than wages.  Every year our same dollars bought less and less. 
When inflation takes hold, it's hard to stop.  People want more money to afford what they could afford last year.  If they get raises, however, their businesses have to raise prices to cover higher payroll costs, so costs rise.  A vicious circle ensues, where labor wants raises and businesses want higher prices.  What stops the circle?  A recession, when businesses lay off workers and can contain prices.  The higher inflation, the more prolonged the recession.
The problem is, during the recession, the Fed is pressured to lower interest rates to stimulate the economy.  But, r
Once inflation takes hold, it's very hard to stop.
A Dovish Policymaker
Janet Yellin is described as an inflation "dove."  That means that her decisions have been "growth and employment" oriented and less focused on containment of inflation.  You may think, that with unemployment rates hovering in the double-digits, this is just what we need.  Certainly, that political opinion would be currently popular.  But, would it be a good long term policy?
Deficits and Inflation
No reputable economist of whom I'm aware would not have advised deficit spending to stimulate the economy during the last recession.  It was a necessary evil that prevented the country from likely sinking into a Depression.  But historically, the relationship between deficit spending and inflation is problematic.
Generally, when government borrowing increases, the amount of funds that remains for businesses and individuals to borrow decreases, and the competition for these fewer dollars causes rates to increase. 
So-called inflation "doves," who generally advise keeping rates low, can accommodate both government and business lending only by printing more money for the government to buy its own debt, causing the money supply to expand and debt to contract.
Expanding the money supply is inflationary.  Instead of raising taxes to pay its debt, printing more money makes the dollar less valuable.  The cost of everything goes up when your dollar is worth less.
The Federal Reserve Board of Governors
At its last meeting, only one Fed governor, that of St. Louis, voted against keeping interest rates low.  The majority (11 members) voted to keep rates low because their perception that the risk of sinking back into recession was more significant than the threat of inflation.  Dr. Bernanke, current Fed chairman, is considered one of the premier scholars of the Great Depression.  One significant factor in its length is thought to be insufficient economic stimulus.  It is a mistake about which Bernanke argues eloquently, and apparently the majority of the board agrees.
With a propensity of more dovish members, however, it is of some concern that one who has been one of the most consistent would be considered as the Vice Chair.  Generally, upon the retirement or failure to reappoint the Chair, the Vice Chair is likely to assume this influential post.
At a time when deficit spending is so high, the national debt is ballooning and the nation only recently stepped back from the brink of Depression, is it wise to choose a member who is so dovish about inflation that she stated last February, "If it were possible to take interest rates into negative territory I would be voting for that."?
Perhaps a candidate with a more balanced approach to the Fed's dual mandate would be a more reasonable decision.

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