|El-Erian, Mohamed A.|
EACH OF THE LAST THREE CHAIRS of the U.S. Federal Reserve faced daunting challenges soon after assuming leadership of the world's most powerful central bank. It will be no different for
Back in 1979,
Success was far from obvious in Volcker's early days, however, and it would not have materialized without his now-legendary steadfastness and conviction. With sky-high interest rates throwing the economy into recession, he faced enormous political pressures to abandon course, including from
Bernanke was forced to do more than just come up with innovative Fed instruments to slow the metastasizing market failures that were sucking liquidity out of virtually every major economic interaction worldwide. Together with Treasury Secretary
Yellen takes over a Fed that is playing an unusually broad role in supporting markets and the global economy. The institution finds itself deep in experimental mode, using largely untested tools–be it purchasing tens of billions worth of bonds a month, keeping interest rates artificially floored, or seeking to influence private-sector behavior by venturing ever deeper into "forward policy guidance" (basically, orchestrated communication to markets about the Fed's intentions).
There are few historical parallels, analytical models, and policy playbooks to guide her. Indeed, there isn't even a common and detailed understanding among academics of how the Fed has really influenced economic prospects and the functioning of markets since the global financial crisis. Meanwhile, financial investors are delighted to have the continuous support of the Fed's wide-open wallet, which has driven asset prices to rise to historical records, despite unusually sluggish fundamentals.
It's not quite a poisoned chalice, but Yellen is taking over a Federal Reserve that has ended up, mostly inadvertently, underwriting a series of consequential and unusual disconnects. Under her guidance, the Fed will need to find a way to better reconcile booming financial asset prices with the unfortunate realities of what is now being labeled "secular stagnation"–an unusually prolonged period of low growth and high unemployment. The central bank will also have to find a way to reconcile its steadfast commitment to supporting the domestic economy with the disruption that causes for other countries. After all, with
Yet the Fed under Yellen will need to find a way to transition the economy from artificial growth to genuine private-sector-led growth. It must gradually reduce its direct involvement in the markets and do so without causing disorder that undermines economic growth. Bernanke has already signaled the route ahead: namely, a gradual retreat from monthly bond purchases in favor of great reliance on forward policy guidance.
There may be no imminent crises like the ones Volcker, Greenspan, and Bernanke faced. Yet the situation Yellen inherits is arguably more complicated and fluid. Indeed, it may well constitute one of the most complex challenges ever faced by a central bank. If that weren't enough, the Fed's tool kit is ill-equipped for the task at hand, and the institution is hampered by political polarization and congressional dysfunction.
No one knows for sure how much time the Fed has before it must deal with the unintended consequences of its experimental policies. It could be months; it could be years. Much depends on whether Bernanke has actually bought enough time for U.S. household balance sheets to heal and for the economy to pick back up robustly.
But Yellen can't wait to find out. She needs to deliver on four interrelated fronts early on in her tenure. First, as the benefits of the Fed's unconventional stimulus decline, as they inevitably will, she must avoid exposing the fragility of a recovery still hampered by inadequate infrastructure and demand, unresolved pockets of excessive indebtedness, and long-term unemployment.
Second, with many equities and corporate bonds flirting with bubble-ish levels, she must work with other agencies to ensure that recent progress in banking regulation and supervision has materially reduced the threat of destabilizing market incidents.
Third, she must find a way of breaking the unhealthy co-dependency that has developed between markets and the Fed. Markets cannot function well in the long term on the assumption that they will always have the Fed to support them, and the Fed cannot always rely on artificially boosting financial assets to promote growth and jobs.
And fourth, she must clearly communicate Fed policy in a world that has become extremely sensitive to every word, signal, and whisper emanating from the world's most powerful financial institution.
What is undeniable, even at this early stage, is that the to-do list awaiting
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