After three years of almost single-handedly juicing up the slow-growing economy, Janet L. Yellen and the Federal Reserve should be looking at easier days ahead.
Yellen, in what will probably be her last full year as Fed chair, may finally get help from somewhere else in Washington.
Tax cuts and infrastructure spending planned by President-elect Donald Trump, if backed by the Republican-controlled Congress, would lighten the load for a Fed whose easy-money policies have been the primary economic support for the nation.
She is already breathing easier on the Fed’s employment mandate; the jobless rate has fallen to a nine-year low of 4.6%. Inflation, too, is under control and, by all accounts, creeping toward the central bank’s optimal level of 2%.
And yet, Yellen may come under as much economic and political pressure as ever, on both the Fed’s policy and the independence of the institution.
The Trump administration is almost certain to push back as she and her colleagues lift interest rates from historical lows. The Fed began with a small increase in its benchmark rate earlier this month, only the second rise in more than a decade. But officials signaled a quickening of rate hikes in 2017.
As a presidential candidate, Trump offered contradictory views when it came to the Fed. He first applauded Yellen, saying he, too, was a “low-interest-rate person.” Later he accused the Fed leader of keeping rates low for political reasons and said he would most likely replace Yellen when her four-year term expires in early 2018. Trump’s pick for Treasury secretary, Steven Mnuchin, said after his selection that he thinks Yellen has done a good job.
No one knows for sure where Trump and his economic team stand on monetary policy. The New York real estate developer, who has capitalized on cheap rates, didn’t comment or tweet about the Fed’s widely expected rate bump on Dec. 14. But if history is any guide, he’s not likely to favor faster interest rate increases. “No president ever does,” said Alice Rivlin, a former Fed vice chairwoman from 1996 to 1999.
That’s because higher interest rates increase borrowing costs for businesses and consumers, which tends to slow lending and investments. The interest-sensitive housing market will be particularly vulnerable. The 10-year bond yield, a benchmark for mortgages, already has jumped to 2.6% from 1.8% in early November, on expectations that a major fiscal stimulus would lift economic growth and inflation.
Fed policymakers have forecast the equivalent of three quarter-point rate increases for next year, but some economists see four or more hikes coming. And while Yellen has been cautious to reserve judgment on any anticipated fiscal stimulus, she seemed somewhat cool to the idea when asked at a news conference immediately after the Fed’s rate increase announcement.
“I do want to make clear that I have not recommended running a hot economy as some sort of experiment,” she said.
Like other economists, Yellen may be questioning whether this is the right time for a massive fiscal stimulus. Given that the economy is at or near full employment – the point where much faster growth could spur inflation – Yellen will be watching carefully and could “take away the punch bowl just as the party gets going,” as the famous saying goes on the Fed’s job to keep the economy from overheating.
Joseph Gagnon, a former Fed economist and a fellow at the Peterson Institute for International Economics, said he couldn’t recall a period when there was a large fiscal injection at a time the economy was at full employment. The last big stimulus package, about $800 billion of federal spending and tax cuts, was passed at the start of President Obama’s first term in early 2009 to fight the Great Recession.
“The opportunity for fiscal stimulus in doing good is gone,” Gagnon said, arguing that if anything, it would only cause the Fed to raise rates faster. With more money chasing higher rates in the U.S., he said, that would push up the dollar, which in turn would hurt the housing market and Trump’s effort to correct the nation’s trade imbalance.
As former Fed officials and historians know, White House staff in the past, for example in the Nixon administration, leaned on the Fed to back off raising rates and keep the money supply flowing. Even so, most economists don’t think Trump should be worried about Yellen taking away the punch bowl.
For one thing, even if the Fed raised rates four times next year, the so-called federal funds rate would still probably end 2017 at 1.5% to 1.75% — well below normal for the benchmark overnight lending level. “Yellen’s largely off the hook for being a spoiler next year. She won’t be able to raise rates far enough to make a difference,” said Chris Rupkey, managing director at Mitsubishi UFG Financial Group in New York.
Rather than from the Fed, the Trump administration is more likely to face constraints from financial markets as investors react to prospects of faster economic growth and inflation, says Lynn Reaser, chief economist for Point Loma Nazarene University in San Diego. “The challenge to fiscal policy, interest rates and the dollar – those are not being led by the Fed but by the markets,” she said.
At the moment, it’s hard to see inflation getting out of hand. Inflation has been well below the Fed’s 2% target over the last few years and most recently was running about 1.5%.
Wage gains are starting to pick up. But the stronger dollar and global competitive pressures on commodities and other goods are curbing inflation, as is a major predictor of future inflation: consumer expectations of price increases. Rivlin, the former Fed vice chairwoman, says one indication of just how tempered those expectations are can be seen in the mock exercise she does with her students.
“I can’t even get them interested in inflation as a threat,” she said. “These are 20-somethings and they’ve never heard of inflation — and that’s a very large portion of the population.”
To be sure, Yellen and the Fed could determine that the economic engine is running too fast and then act more aggressively to slow growth, in effect leading, not following, the markets in setting higher interest rates. That would more likely put the Fed in the crosshairs of the new president, who has spoken of doubling annual economic growth to 4%.
I think her public relations operation is going to have to be strong.
“It very definitely could be a dicey year” for Yellen, said Reaser. “It’s a significant turning point from monetary to fiscal policy, and you have the challenge [from Trump] to the notion that a 2% growth track is the new normal.”
On top of potential clashes over policy, Trump and an emboldened Republican-controlled Congress appear eager to rein in the century-old Fed, by authorizing so-called audits of its monetary policy decisions and reducing its regulatory power.
“I expect this is going to be a target of the Trump administration,” said Rep. Maxine Waters (D-Los Angeles), the top Democrat on the House Financial Services Committee. Republican lawmakers have been critical of the Fed since the central bank’s aggressive steps — emergency lending, repeated bond purchases — taken during the financial crisis and slow recovery under Chairman Ben S. Bernanke and then-Vice Chairwoman Yellen. More recently, Waters said, “they have not liked the fact that she’s been responsible for holding down interest rates.”
There are two vacancies on the Fed’s seven-member Board of Governors that Trump will be able to fill, and a third slot could open up if Daniel Tarullo steps down in 2017 as some expect. Yellen, for her part, has made it emphatically clear that she intends to serve out her term as chairwoman until it ends Feb. 3, 2018.
Interest rate policies aside, some influential Republican lawmakers want the Fed to make changes in the way it operates.
“Them getting more sensitive and acknowledging what’s happening in the marketplace does not somehow take away the reason for having more predictability and less opacity,” said Rep. Bill Huizenga (R-Mich.), chairman of the House Financial Services Committee’s monetary policy and trade panel. “Just because they raised rates a quarter point does not suddenly let them off the hook.”
Huizenga’s bill, called the Fed Oversight Reform and Modernization Act, passed the House by 241 to 185 in 2015. The legislation would require the Fed to develop a rule-based formula for interest rate moves and allow the Government Accountability Office to review monetary policy decisions. The Fed’s other activities already are subject to audits and GAO reviews.
“There’s a lot of concern that they’ve continued to get more and more political in terms of their decision-making. They keep saying they want to make their decisions data-driven. What’s the data?” Huizenga said.
Yellen has told lawmakers that enacting the legislation would be “a grave mistake.” She has expressed concerns that additional audits would “politicize monetary policy and bring short-term political pressures into the deliberations.” What’s more, Yellen, like Bernanke before her, has argued that a rule-based formula for interest rate decisions would tie the central bank’s hands, rendering it inflexible to deal with extreme situations such as the Great Recession.
John B. Taylor, a Hoover Institution economist whose name is associated with the Taylor Rule, which prescribes interest rate changes following the movement of inflation and output, has championed the idea that adhering to a rule-based system would help guide the Fed and help the public understand the principles behind the central bank’s actions and when policymakers deviate from them.
Thus far, Yellen and Bernanke have fended off sometimes-intense congressional pressures for tougher restrictions on the institution. Waters, who opposes Huizenga’s bill, said Yellen will need to spend time in 2017 talking with lawmakers to try to stop it.
Yellen has met frequently with members of Congress from both parties, and that is expected to continue, if not increase. For the first 10 months of this year, Yellen’s publicly released calendar showed 27 phone calls or face-to-face meetings with House and Senate members.
“I think her public relations operation is going to have to be strong,” Waters said.
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