The Most Powerful Woman in the World

On February 1st, Janet Louise Yellen, will become the most powerful woman in the world. At the independent Fed, the Chairman must occasionally answer badly informed and sometimes snarky questions from congress but other than a cumbersome impeachment process (see Gonzalez v. Volker, 1985) there is little oversight for the central bank. They are not subject to the congressional budget allocations as their own operations generate sufficient cash flow to pay for whatever they need. This was by design and has served us well for the last 100 years. With almost complete autonomy and policy flexibility the Fed Chairman easily has more power and influence on the economy than either the President or the Congress.

All the smart prognosticators see Janet Yellen as a very soft touch on monetary policy. Indeed, the assurance of continued easy money (refilling the party punch bowl as the colloquialism goes) was what prompted an unprecedented petition by a large group of senators recommending her nomination to President Obama. Whatever his own preferences, the president followed their instructions, turning the normal constitutional advise and consent process on its head. In this case, the Senate advised and the President consented.

I’ve met Yellen a few times and have observed her actions as President of the San Francisco Fed. For some years I even ghost-wrote answers to the questions asked of one of her board members. My sense is that her monetary policy view is much more nuanced than what was implied in that partisan Senate petition.

People often change when they rise to the pinnacle of power. The compromises they made that helped paved the way of their ascension are no longer necessary. Perhaps Yellen will evolve into a tough no-nonsense Margaret Thatcher or Golda Meir type. The rich excesses of the financial markets in the last few years cry out for a stern grandmotherly regulator that will set clear limits and apply harsh remedies as necessary.

I also hope to see her evolve as a vocal and powerful advocate for free markets and the creativity and economic growth they engender. A voice for limited intervention, allowing markets to find their own price levels, efficiently allocating economic resources. I know, I know – dream on.

No matter what your monetary policy perspective it is impossible to disagree with the observation that the Fed is in a very odd place. I once worried to former Vice Chairman Kohn, that the Fed would become so enamored with the power of manipulating the broader treasury market that they would never be able to stop. He assured me that would never happen. Since that conversation, the Fed has quantitatively-eased another $2 trillion onto its balance sheet.

For the first 95 years of its history, other than a spike after 9/11, the U.S. banking system managed with less than $10 billion in excess reserves. (See chart) Then in response to the financial crises of 2008, The Fed started pumping liquidity into the economy at a rapid rate. Since then excess reserves have increased more than 200-fold to a whopping $2.4 trillion.

excess reserves chart

Remember that excess reserves can be used to increase lending. Assuming a leverage of eight to one against these reserves means that the unused lending capacity of U.S. banks is near $20 trillion. The reserves are excess because the failed recovery from the recession of 2009, has put a damper on loan demand and the pinch of Dodd-Frank regulations (not to mention multi-billion dollar fines) has made bankers increasingly risk averse.

Normally, an increase in the money supply on this scale is a harbinger of inflation. But prices remain tame. All that liquidity must have gone somewhere. It has washed up in overseas markets, the U.S. stock market and more recently, residential real estate. What will happen to these markets when the Fed shrinks its balance sheet from $3.5 trillion to a more normal $1 trillion is the subject of much debate.

Predicting the consequences of government intervention in markets is often difficult. The massive intervention in mortgages by Fannie Mae and Freddie Mac produced the sub-prime meltdown that disrupted financial markets globally. The more recent government takeover of the student loan market has produced an alarming increase in delinquencies that will eventually lead to large losses for taxpayers. The unexpected ripple effects of Obamacare are only now beginning to surface.

The same is true of the Fed’s intervention in the treasury and mortgage markets.

How would rates respond if the Fed unloaded their extra $2.5 trillion in treasuries and mortgage securities? What would be the bid-to-cover ratio in the treasury auction if the Fed weren’t there to pick up the slack? Are corporate planners really using this manipulated risk-free rate in their net prevent value calculations? Would investment volume come crashing down if the ten-year treasury were at five percent instead of three?

Ben Bernanke drove the Fed into this blind alley and it will be Janet Yellen’s job to find a way out. By now we should all understand not only the limits to fiscal stimulus but, as important, the limits to monetary policy. The Fed, as powerful as they are, cannot right all wrongs.

So there are two questions here. Conceptually, will the new Chairman set some limits to the Fed’s intervention? And, if there are limits, how and when will the transition to a less interventionist Fed take place?

As we pointed out above, the conventional wisdom is that Janet Yellen will be an even more activist Chairman than Bernanke who saw the Fed’s role going well beyond sound money and full employment. If they are correct, a few years from now we will have a $5 trillion central bank, badly distorted bond markets and a continuing erosion of the greenback internationally. For the good of the U.S. and the global economy, we hope the conventional wisdom is wrong.