The biggest question on monetary policy for the years ahead is, who will be the next Federal Reserve chairman? More importantly, who is best qualified to normalize policy without disrupting the current pace of economic growth and financial stability? The clear choice is Chairman Ben Bernanke, who nursed an ailing economy and financial market back to health by using unprecedented unconventional monetary policy. However, while it has not been explicitly stated, it is widely thought that Bernanke's second term as chairman will be his last (his term as Board member will not expire until 2020). How do we know this? Well, the chairman has done almost everything to point us in that direction besides spelling it out.
For starters, the chairman broke his typical stoic public routine and quipped in a speech to recent Princeton graduates, "I wrote recently to inquire about the status of my leave from the university (Princeton), and the letter I got back began, 'Regrettably, Princeton receives many more qualified applicants for faculty positions than we can accommodate.'" If humor on a possible exit is not enough to make the case for a near-term exit, it was recently reported that President Obama is in the process of interviewing: Larry Summers, Janet Yellen and Donald Kohn. The omission of Chairman Bernanke's name is noticeable and follows similar sentiment relayed in an interview on Charlie Rose, in which the president noted the chairman "has already stayed a lot longer than he wanted or he was supposed to." With the tea leaves all suggesting an exit for the current chairman, we now focus our attention on Bernanke's successor.
In this brief note, we revisit a framework originally laid out by Christina Romer and David Romer in a 2004 paper entitled, "Choosing the Federal Reserve Chair: Lessons from History." The authors contend that the best way to choose a Fed successor is to be familiar with the candidates' views on how the economy works and understand their underlying economic beliefs. The authors find that in periods where policy was successful, the previous views of the Fed chairmen showed that they were acutely aware of the high costs of inflation and its determinants and had realistic views about the sustainable level of unemployment. Monetary policy was said to be successful under William Martin, Paul Volcker and Alan Greenspan, who shared the view that inflation was harmful and that economic slack could reduce inflation (see Table 2). They also understood that under certain conditions, monetary policy could stimulate a depressed economy.
Background and experience are also important as every past chair in the Fed's history has either had fiscal policy experience and/or private-sector experience. Bernanke, Greenspan and Arthur Burns all served as chair of the Council Economic Advisors (CEA); and Marriner Eccles, Martin and G. William Miller were all businessmen (see Table 2). By far, the most desirable pick would be someone who is well-rounded with a background in the private sector, fiscal and monetary policy. To date, Paul Volcker is the only chair who came to the table with all three skill sets.
While the Romer and Romer (2004) study trails off at the Greenspan era, we augment the timeline by exploring the background and underlying economic beliefs of Bernanke, then follow the same logic to consider the top candidates being discussed by the Administration and the media. We focus on Larry Summers and Janet Yellen and explore their most recent views on inflation, employment, and financial stability.
Added Uncertainty: Timing of the Announcement and Process
Before delving into the ideologies of the proposed candidates, we first consider the timing of the nomination announcement and the process. In a recent news conference, President Obama indicated the top two candidates—Janet Yellen and Larry Summers—are both highly qualified and that he will make his decision in the fall. That said, we will likely hear the official word from the White House in late September or October, which is about two months before the current term expires.
With this timetable, the announcement bumps up against a number of key dates including the September FOMC meeting and press conference, when we expect the Fed to announce plans to taper the current pace of asset purchases, the continuing budget resolution, which could result in a government shutdown on October 1, and the debt ceiling, which will likely be reached in mid-October. A contentious nomination during this period could add to the already-high level of uncertainty.
Once the President makes the nomination, the nominee will appear before the Senate, more specifically the Senate Committee on Banking, Housing and Urban Affairs. The nominee then reads a prepared statement and responds to written questions from the Senators. Thereafter, the entire Senate will vote to confirm the nominee. With at least one nominee ruffling feathers, it is not out of the realm of possibility that a nominee could be rejected. With the exception of the Wilson Administration during the beginning stages of the Fed, no Fed chair nominee has ever been rejected. With such a late announcement, if the nominee fails to get confirmed, we could be well past the end of Chairman Bernanke's term of January 31, 2014 before a new chair is chosen. While Bernanke could stay on as a board member until the vacant seat is filled, the Administration will likely take the necessary steps to ensure a smooth nomination process.
Bernanke's Legacy: The Helicopter Is Landing
Time Magazine took an early stab at writing the chairman's legacy by naming him "Man of the Year" in 2009. While the unwinding of the Fed's unprecedented asset purchase program will truly determine Bernanke's legacy, it cannot be refuted that that the chairman resuscitated a very sick patient (the economy) from highly critical to stable condition. That said, we tested the framework proposed by Romer and Romer (2004) and found that his views on unconventional monetary policy, the zero-lower bound, and inflation targeting were all noted in his earlier academic work.
In a 2002 speech, Bernanke addresses the role of unconventional monetary policy and its impact should the federal funds rate be pushed to the zero-lower bound. He said, "to stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys." Bernanke even remarked that another approach to cap the yield on longer-dated Treasuries is "...to operate in the markets for agency debt."
Bernanke's stance on inflation was also clearly discernible prior to his chairmanship. In a piece he co-authored in 1999, "What Happens When Greenspan Is Gone?" Bernanke proposed inflation targeting as the most desirable policy framework going forward, stating that, "inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation....but also promotes a more open and accountable policy-making process." Regarding his view on driving the inflation rate down to zero, promulgated during the Volcker and Greenspan era, Bernanke parted with the prevailing wisdom by arguing that the "...long-run inflation rate that best promotes the dual mandate is likely to be low but not zero."
In addition, the chairman pioneered a shift in communication to increased Fed transparency, which was foreshadowed in his prepared remarks at the nomination hearing. The move toward greater transparency stemmed from a belief that increased communication "reduces uncertainty in financial markets, and helps to anchor the public's expectations of long-run inflation."
Fast-forward to his time as chairman, most of the discussed policies in his earlier work were implemented. Reviewing Bernanke's work prior to becoming chairman further makes the point that understanding the underlying economic beliefs prior to nomination is the best way to determine what to expect during the tenure of the named Fed chairman.
Janet Yellen: The Playbook is Well Known
By many accounts, Janet Yellen is considered to be the frontrunner for the nomination. In fact, most suspect that to ensure a soft landing for unwinding the unprecedented expansion of the Fed's balance sheet, the similarly "dovish" vice chairwoman, who helped craft much of the current monetary policy, is best suited for the job. There is also a greater likelihood that Yellen would continue with Bernanke's well known consensus-driven approach to decision making. However, the only knock on her background is that she lacks private sector experience. Her views on employment and inflation are well noted. In a recent speech she states, "... I believe progress on reducing unemployment should take center stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding two percent." This view of a little more inflation for a lower unemployment rate has some investors worried that she could overweight employment at the expense of inflation. On the flip side, other investors would be happy to see Yellen as chair, as there would likely be fewer surprises and greater possibility for a smooth confirmation.
Regarding financial regulation, Janet Yellen believes we have only scratched the surface with current Basel III and Dodd Frank standards. In a recent speech about the regulatory landscape, Yellen says, "Although we have made the financial system safer, important work remains" in banking regulation, problems with systematically important financing institutions and limiting risks in the shadow banking and financial markets. More specifically, Yellen espouses that resurrecting efforts like Glass-Steagall are "...the most efficient ways to address the too-big-to-fail problem."
Larry Summers: Contentious, but Qualified
Larry Summers' economic background is very impressive with private sector, academic and extensive public service experience. His early views on inflation and employment are well documented in his academic work. Similar to Bernanke and Yellen, Larry Summers believes that "...positive rates of inflation are almost certainly desirable" and the optimal inflation rate is "...perhaps as high as 2 or 3 percent." So, the idea of a little inflation to reduce the unemployment rate would likely carry through with Larry Summers as Fed chair.
Summers also believes employment should be a priority. He believes economic growth and job creation "...should become the focus of our national economic conversation." He also supports the view that monetary policy can help spur employment. In an earlier paper he noted, "in a high-unemployment trap, it may be well desirable to use monetary policy to jolt the economy out of that trap."
Despite helping to deregulate the banking industry during the Clinton Administration, Summers' recent comments suggest that he is in favor of financial reform. While chair of the CEA, he noted that, "We have seen strong progress in both chambers, with the passage of a financial reform bill under Chairman Frank's leadership in the House and the announcement of a financial reform bill under Chairman Dodd's leadership" He even goes on further to lay out what additional reform is needed.
Finally, Summers' academic work is likely where we find his true underlying economic beliefs, as he tends to restrain his own view when acting in an official capacity. In a recent speech, he notes, "It has been my observation that one can speak freely—more freely, at least-- ...outside of public office than in public office." This line of thinking is likely why his stance on regulation has shifted in recent years.
One of the most important economic decisions for the years ahead is who will be the next Fed chair. While the media has considered intangible traits, such as personality, to be important criteria, we revisit logic used in an earlier paper by Romer and Romer (2004). In the paper, the authors vet proposed candidates by understanding their views on the Fed's dual mandate and understand their underlying economic beliefs.
Using the same framework to explore the background and underlying economic beliefs of Ben Bernanke we see that his stance on unconventional monetary policy, the zero-lower bound, and inflation targeting were all noted in his earlier academic work. We follow the same logic to consider the views of Larry Summers and Janet Yellen on inflation, employment, and financial stability.
We find that it is very hard to delineate between the top two candidates views on monetary policy, financial stability and the current regulatory framework. On background and experience, every past chair in the Fed's history has either had fiscal policy experience and/or private sector experience. Janet Yellen and Larry Summers also have impressive backgrounds, but Yellen lacks experience in the private sector. Another sticking point will likely be in the decision making process. We suspect there is a greater likelihood that Yellen would continue with Bernanke's well known consensus driven approach. Despite a difference in the decision making process, personality and private-sector experience - which are menial - we can hardly find a difference in the two candidates.