Federal Reserve Governor Janet Yellen appeared before the Senate Banking Committee this week during her confirmation hearing to succeed Ben Bernanke as the new Chairwoman of the Federal Reserve. Arguably, this position may be superseded only by the President of the United States in its influence on the levers of global economic power. For this reason, and as a result of the unprecedented initiatives that the Fed has implemented since the Great Recession of 2008, investors have been laser-focused on the potential policy changes under a Yellen chairmanship.
The debate continues to rage over the effectiveness of the Fed's attempts to stimulate the economy by aggressively buying treasury bonds and mortgage securities ("quantitative easing" or QE). Proponents of the strategy argue that lower interest rates caused by QE have allowed consumers and businesses to dramatically reduce their debt burdens, and lower mortgage rates have resurrected the moribund housing market. While the economic recovery has been sluggish they argue, conditions would be much worse had the Fed not undertaken these aggressive steps (an impossible hypothesis to prove if there ever was one).
Critics of the strategy argue that all of this bond buying has distorted the normal functions of the fixed income market by setting the level of interest rates at artificially low levels, and has sown the seeds for slower growth and higher inflation in the future. They worry about the process of "unwinding" the Fed's $4 trillion balance sheet and its impact on markets across the globe.
Ms. Yellen set a predictably middle-of-the-road course during her testimony, arguing for the benefits of QE but also noting the risks of continuing the practice for too long. Although most observers view her as more dovish than her predecessor (i.e. that she is likely to maintain QE for longer), her record at the Fed is decidedly more nuanced. She testified that she voted to raise interest rates more than twenty times during her tenure as a Fed governor, while never voting for a rate reduction.
If Yellen is confirmed as expected, she will ascend to the chairmanship of the Federal Reserve at an unusually challenging time. Judging from the market's violent reaction to Chairman Bernanke's foreshadowing of an eventual desire to reduce QE (when interest rose by more than 100 basis points and the housing recovery slowed dramatically), weaning the economy off of four years of monetary stimulus without significant damage to investor confidence will be a true high wire act.
We are optimistic that Yellen will provide informed, thoughtful leadership to the members of the Federal Open Market Committee, and that her decisions will be based on carrying out the dual mandate of the Fed of low unemployment and price stability. Our expectation is that the economy will exhibit continued modest improvement next year, providing her with the opportunity to begin the "great unwind" sometime in early 2014 with only temporary damage to financial markets. Nonetheless, we will be closely monitoring the situation and will be prepared to adjust strategies accordingly should conditions change.
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