Larry Summers’s reluctant withdrawal from the beauty contest to become the next Federal Reserve Board chairman doesn’t change the fact that U.S. monetary policy will remain loose for years to come, regardless of who ends up leading the U.S. central bank.
With the American economy far from take-off velocity, the choice between Mr. Summers and current Fed vice-chair Janet Yellen was never a choice between a hawk and a dove; it was always a choice between different degrees of dovishness.
The next Fed chair’s discretion will be constrained by the policies of his or her predecessor. The Fed has already bound its hands with the forward guidance it issued in December, 2012. At that time, Fed policy-makers indicated that the federal funds rate would remain near zero so long as the unemployment rate remains above 6.5 per cent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Fed’s 2-per-cent longer-run goal, and longer-term inflation expectations continue to be well anchored (i.e., consistent with no more than 2-per-cent inflation). They further emphasized that these thresholds are consistent with their earlier guidance that exceptionally low interest rates would be warranted at least through mid-2015. The next Fed chair has little room to move.
Current chairman Ben Bernanke’s successor is unlikely to chafe against this constraint. There is still so much slack in the U.S. economy that the new chair will be unlikely to tighten monetary policy any time soon. Public and private balance sheets will be in debt-reduction mode for years to come, dampening credit extension, investment, employment and growth. The output gap remains wide. Participation in the U.S. labour force just hit its lowest level since 1978. Price increases remain subdued. In this context, there is little for an inflation hawk to attack.
What’s more, the U.S. economy faces continued headwinds on the fiscal front. Federal public spending and employment are being cut even though the economy is still on life support. Congressional wrangling over the budget and the debt ceiling will further inhibit investment, consumption and growth. So long as the fiscal side of U.S. crisis management remains impaired, monetary measures will have to remain heroic.
Given all these challenges, it might seem surprising that Mr. Bernanke has persisted in foreshadowing an imminent tapering of the pace of quantitative easing (QE), the $85-billion (U.S.) of monthly bond purchases that the Fed has used to loosen credit conditions even further than the near-zero federal funds rate managed to achieve. But taper talk isn’t being driven by a few sporadic green shoots of recovery – it’s a response to fears that QE is creating new asset bubbles in housing and equities. The taper is meant to prick these bubbles before they get too far ahead of the recovery. Even if the Fed does taper (but not end) its QE program, its balance sheet will still be expanding. Put differently, the Fed will still be printing money. Monetary policy will be exceptionally accommodative. Tapering is mere trimming around the edges.
The Fed isn’t going to tighten monetary conditions meaningfully any time soon. At its meetings this Tuesday and Wednesday, the bank’s policy-setting Federal Open Market Committee (FOMC) may indicate a gradual easing of the pace of QE, but it will probably couple this with very dovish language on inflation to prevent a knee-jerk back-up in markets. If the taper gets initiated under Mr. Bernanke, the next Fed chair’s views on QE become less consequential.
Moreover, the Fed chair has only one vote among 12 on the FOMC. Unlike the governor of the Bank of Canada, who exercises sole responsibility on policy setting, the Fed chair has to convince these committee colleagues to follow his or her lead. This is a natural check on sharp turns in policy.
The obsession with President Obama’s choice for Fed chair has drawn attention away from the fact that the FOMC is about to undergo several other changes. Regional Fed presidents Richard Fisher and Charles Plosser – both inflation hawks— as well as Minneapolis Fed president Narayana Kocherlakota will rotate into voting positions on the FOMC. Sarah Bloom Ruskin and Sandra Pianalto have announced that they intend to leave the FOMC; Elizabeth Duke has just left. Ms. Yellen may also quit if she is passed over for the chair’s job. Jerome Powell must be reconfirmed early in 2014, and Daniel Tarullo has already been a governor for four years. It’s anyone’s guess where this will leave the general cant of the FOMC in 2014.
Regardless of how the FOMC gets reconfigured, it’s one thing to talk a hawkish line and quite another to act on it. Mr. Bernanke’s clear forward guidance raised the bar for any change in policy – and that bar is unlikely to be hit by U.S. macroeconomic data any time soon. The future credibility of both the FOMC itself and its new members will hinge on respecting past promises – and that makes them all doves now.
Brett House is a senior fellow at the Centre for International Governance Innovation (CIGI), a senior fellow at the Jeanne Sauvé Foundation at McGill University, and a Chazen Visiting Scholar at Columbia Business School. You can follow him on Twitter @BrettEHouse.