AP Photo/Charles Dharapak
President Obama nominates Janet Yellen to chair the Federal Reserve.
Since mid-September, when former U.S. Treasury Secretary Larry Summers withdrew his name from consideration to replace Ben Bernanke as chairman of the Federal Reserve next year, market participants have become increasingly interested in the policy views of current Fed vice-chair Janet Yellen, who is now set to take the reins at the central bank when Bernanke's term expires in January.
One item in particular has become the center of attention for those trying to figure out how a Yellen Fed will be different: the "optimal control" approach to monetary policymaking, as outlined by Yellen in a series of speeches last year.
Michael Feroli, chief U.S. economist at JPMorgan, sums up the idea succinctly in a recent report: "This approach starts with a forecast for the economy, and then solves a large-scale macroeconomic model to find the path of the funds rate that minimizes the deviation of inflation and unemployment from their respective targets."
The Federal Open Market Committee (FOMC) targets an annual inflation rate of 2% over the long run and an unemployment rate of 6% (the latter number an estimate of the economy's "natural" unemployment rate).
Under the optimal control approach, the central bank would then use a model to calculate the optimal path of short-term interest rates in order to hit these targets. As long as unemployment is further away from the target level than inflation, then monetary policymakers would keep interest rates low in an attempt to correct this, even if it means inflation runs slightly above target for a while.
Yellen illustrated the concept in a November 2012 speech. Here's the paragraph explaining how it would work, with relevant charts shown below:
To derive a path for the federal funds rate consistent with the Committee’s enunciated longer-run goals and balanced approach, I assume that monetary policy aims to minimize the deviations of inflation from 2 percent and the deviations of the unemployment rate from 6 percent, with equal weight on both objectives. In computing the best, or "optimal policy," path for the federal funds rate to achieve these objectives, I will assume that the public fully anticipates that the FOMC will follow this optimal plan and is able to assess its effect on the economy.
The blue lines with triangles labeled “Optimal policy” show the resulting paths. The optimal policy to implement this “balanced approach” to minimizing deviations from the inflation and unemployment goals involves keeping the federal funds rate close to zero until early 2016, about two quarters longer than in the illustrative baseline, and keeping the federal funds rate below the baseline path through 2018. This highly accommodative policy path generates a faster reduction in unemployment than in the baseline, while inflation slightly overshoots the Committee’s 2 percent objective for several years.
The upshot of a Yellen Fed employing an optimal control strategy is simply the notion that the central bank would take a more aggressive stance toward fighting above-target unemployment, implying lower short-term rates for longer.
Many believe such a policy shift could become the hallmark of her tenure at the helm of the central bank.
"These paths serve as crucial internal benchmarks to [Yellen's] thinking," says Vincent Reinhart, chief U.S. economist at Morgan Stanley.
Goldman Sachs economists also cite optimal control as one of the reasons they doesn't foresee rate hikes until 2016.
Yet, as Wall Street economists also acknowledge, just because Yellen seems to be a fan of optimal control, that doesn't necessarily mean it becomes the de facto approach.
"While optimal control exercises can be informative, such analyses hinge on the selection of a specific macroeconomic model as well as a set of simplifying assumptions that may be quite unrealistic," said Yellen herself in an April 2012 speech. "I therefore consider it imprudent to place too much weight on the policy prescriptions obtained from these methods, so I simultaneously consider other approaches for gauging the appropriate stance of monetary policy."
JPMorgan's Feroli argues that the FOMC already employs the optimal control approach to some extent in a note to clients:
Optimal control policies are not, per se, a Yellen innovation. At each FOMC meeting the Fed staff prepare the "Bluebook," which presents various policy alternatives. Since at least 2005 -- and intermittently even earlier going back to the 1990s -- the Bluebook has presented the optimal policy path of the funds rate. An example of such a Bluebook optimal policy exhibit is in the chart pasted below, which is from the latest publicly available Bluebook, from the December 2007 FOMC meeting. Technical documentation can be found here .
This optimal policy prepared by the staff uses the same loss function that Yellen used in her speeches: the squared errors of the inflation and unemployment rate from their targets, as well as the square of the quarterly change in the funds rate. The important point is that it would be incorrect to think of this as the "Yellen optimal control policy," but rather a long-standing product of the Fed's forecasting staff.
And even if Yellen tries to move FOMC policymaking further in this direction, Société Générale chief U.S. economist Aneta Markowska argues she would likely have trouble doing so.
"Yellen would probably face strong resistance from other FOMC members and would have a hard time building consensus around such a radical view," writes Markowska in a note. " Given the Fed’s projections that the economy will be operating near full capacity by late 2016, guiding toward zero rates at that time would be incredibly risky: it could cause excessive risk taking or even worse, dislocate long-term inflation expectations, ultimately forcing a more aggressive tightening scenario. Given this dynamic, we suspect that forward guidance has been stretched to a limit and any further attempts to push down on the short-end of the curve could simply cause dislocations at the long-end."
Furthermore, the optimal control approach doesn't really account for the risk of asset bubbles caused by overly-stimulative Fed policy, something to which Steven Englander, global head of G-10 FX strategy at Citi, believes much of the FOMC is still highly attentive.
"A number of clients have expressed concern about financial markets under a policy path that stays so aggressive for so long," he writes in a recent note. "Even if everything is correctly specified in the model, the risk is that investors take this policy as a 'westward-ho' for risk taking. Fed funds at zero for many years could stimulate another round of bidding up asset prices and another set of bubble related issues."
"The suspicion is that in the event, the Fed will pursue more cautious policy to avert another bubble," Englander continues. "Bottom line is that investors believe that financial stability is somewhere in the Fed's true objective function even if does not seem to play a big role in their optimal control simulations. It actually should be read as a compliment to the Fed."
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