Yellen’s Confirmation: Doves Rule the Roost at the Federal Reserve

The Cheat Sheet

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The U.S. Senate voted 56-26 on Monday to confirm Janet Yellen as the next chair of the Federal Reserve. Yellen will assume office as the 15th chair of the central bank on January 31, when current Chair Ben Bernanke concludes his second term. She will be the first female to lead the Fed, and will join a small pantheon of top female central bankers from around the world.

With the confirmation, the conversation surrounding monetary policy in the U.S. has shifted toward Yellen and how she will lead the decision-making process at the Federal Reserve. The institution has generally leaned toward the dovish side of the spectrum in recent years, but the historic line dividing monetary policymakers lost some of its divisive power in the wake of the financial crisis.

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With inflation running low even in the face of massive and ongoing quantitative easing, and with unemployment stubbornly high, the doves ruled the roost at the bank. Over the past 12 months, in particular, there has hardly been any inflationary pressure to worry about at all. The price index for personal consumption expenditures increased just 0.9 percent on the year in November. In May, Bernanke even warned about “incipient deflationary pressures” held at bay by the Fed’s accommodative monetary policy.

Yellen is a Democrat and appears to lean to the dovish side of the spectrum. Media outlets — guilty as charged — have collectively latched on to a comment from 1995 as evidence of her position in the eternal debate between unemployment and inflation. That year, as the economy continued to expand in the wake of the recession that ended in 1991 and the so-called “new economy” was developing, then-Chair Alan Greenspan led the Federal Open Market Committee (Yellen was on the Board of Governors at the time) in a debate about inflation targeting.

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Yellen now famously argued that unemployment could also be used as a target — and may even be a preferable target — over inflation when it is impossible to pursue both in harmony. “When the goals conflict and it comes to calling for tough tradeoffs,” she said in 1995,” to me, a wise and humane policy is occasionally to let inflation rise even when inflation is running above target…When I look at the behavior of the FOMC and other central banks, I simply can’t find a lot of cases in which monetary policy has ever been driven by an exclusive focus on inflation performance.”

The thinking revealed by her comment is particularly relevant to the Fed’s current monetary strategy. Targeting, in the form of forward guidance, has come to dominate the conversation, and the unemployment threshold was edited when the taper was announced.

The taper, which reduced the flow rate of QE3 asset purchases from $85 billion to $75 billion per month, was a landmark event. Its significance, though, comes in two flavors. The first is how the actual reduction in purchases will affect financial markets and, through them, the economy; the second is how the evolving policy will affect the expectations of market participants.

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The sentiment of private sector and market decision makers is based in no small part on the clarity and tone of the economic outlook. If the outlook is limited or gloomy, businesses are unlikely to spend money or hire new workers (read:do economically stimulating things). If the outlook is clear, though, businesses are more likely to engage in behaviors that economists like to see, such as hiring and spending.

With this in mind, it is important to understand that the Fed — and, in particular, the Fed chair — has assumed the role of general physician for the economy and has been prescribing the medicine necessary to facilitate the recovery. The Fed is charged with setting expectations for how much of this medication will be prescribed and how the dosage will be reduced moving forward.

Since QE is a major tailwind for the recovery, the schedule of the taper is a central part of the outlook. Yellen’s position on the dovish side of the spectrum has led some observers to believe that monetary policy will remain more accommodative for longer than if a more hawkish economist had taken over.

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