Janet Yellen vs. Larry Summers. Who will be the next Fed Chairman?

Within the next few months the Obama administration is expected to announce a nominee for Ben Bernanke's replacement. Two names have been bounced around recently:  Janet Yellen and Larry Summers. According to Google Trends, here is what Google news searches look like over time for these two candidates.

Source: Google Trends

Not surprisingly, researchers at Credit Suisse have recently picked up on this trend.

CS: - ... Fed Vice Chair Janet Yellen was seen as the most likely successor to Bernanke. But within the past couple weeks, former Treasury Secretary Lawrence Summers’ name has come up as a serious contender for the post.

Yesterday Ezra Klein published a nice article on the topic, listing 5 different considerations that may drive this shift toward Larry Summers.

Ezra Klein, WP: - The word among Federal Reserve watchers right now is that the choice is down to Janet Yellen or Larry Summers as Ben Bernanke’s replacement. I can’t find anyone who really thinks it’ll be Roger Ferguson, Tim Geithner, Alan Blinder, or some other dark horse.

People dismissed Summers’s chances a month or two ago, but he’s increasingly viewed as the leading candidate today — and opinions on this, for reasons I don’t fully understand (though I suspect have to do with a bunch of elite trial balloons going up at the same time), have really hardened in the last 72 hours.

According to Klein, Summers has a key advantage in the fact that Obama knows and likes him. The President also tends to surround himself with his ex colleagues and friends and he doesn't personally know Yellen. Another potential negative for Yellen, who is a highly accomplished economist, is her fairly dovish stance on monetary policy.

CS: - Yellen’s rhetoric occasionally comes across as more dovish than Bernanke’s, and some wonder whether, as chair, she would advocate tolerating a higher rate of inflation in pursuit of job growth.

While her public stance has been consistent with the FOMC majority, some in the Obama administration may view her dovish statements of the past as a potential hurdle for what is sure to become a contentious confirmation process. Right now the bet is on Larry Summers.

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From our sponsor:

Bernanke signals the Fed is uneasy with "reaching for yield"

As Merrill's junk bond index yield crossed the historical low of 5% on Thursday, some senior Fed officials are clearly becoming uneasy. Corporate credit markets are entering bubble territory (see discussion) and up until recently very little has been said on the topic by the US central bank. On Friday Ben Bernanke sent a signal to the markets that the Fed is watching the "reaching for yield" situation "particularly closely".

Ben Bernanke (May 10, 2013) - ... We follow developments in markets for a wide range of assets, including public and private fixed-income instruments, corporate equities, real estate, commodities, and structured credit products, among others. Foreign as well as domestic markets receive close attention, as do global linkages, such as the effects of the ongoing European fiscal and banking problems on U.S. markets.

Not surprisingly, we try to identify unusual patterns in valuations, such as historically high or low ratios of prices to earnings in equity markets. We use a variety of models and methods; for example, we use empirical models of default risk and risk premiums to analyze credit spreads in corporate bond markets. These assessments are complemented by other information, including measures of volumes, liquidity, and market functioning, as well as intelligence gleaned from market participants and outside analysts. In light of the current low interest rate environment, we are watching particularly closely for instances of "reaching for yield" and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

The chart below must give at least some US central bankers a reason to reflect on the current pace of monetary expansion. What "unusual patterns in valuations" will another $1.5 trillion of securities purchases create? The FOMC is likely to have at least some debate on the topic at the next meeting.

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From our sponsor:

With the world watching, Bernanke gives a go-ahead to the currency war

In the past few weeks global markets have focused on the weakening yen, as politicians and business leaders, particularly in Europe have called for a halt in Japan's "weak currency" policy. Tokyo's efforts to stimulate it's export sector have become front and center topic in the financial media, as global businesses become increasingly concerned about the currency war. In fact the number of FT articles containing the word "yen" hit a record recently.

Number of FT articles containing “yen” (source: Merrill Lynch)

Similarly, Google search frequency for "JPY" rose recently as well.

Google Trends for "JPY"

Public's attention has therefore turned to the G20 meeting this week, where some have hoped Japan would be asked to moderate its policy. The Eurozone is particularly concerned that the relative strength of the euro will delay its exit from the economic malaise. Germany for example is in direct competition with Japan in auto sales, and a relatively small change in the EUR/JPY levels could result in major differences in sales and profit margins.

But with the world watching and the Germans hoping for action against Japan, the US quickly stepped in to support Japan's policy. After all the US has been following a similar policy itself. This NY Times article described the situation quite well:

NY Times: - Ben S. Bernanke, the Federal Reserve chairman, strongly indicated on Friday that the United States did not intend to censure Japan for weakening its currency over the last several months, something that has aided Japanese exporters and angered its competitors.

Mr. Bernanke spoke in brief introductory remarks at a conference in Moscow of the Group of 20, a club of the world’s largest industrial and emerging economies.

At issue are stimulus programs backed by Prime Minister Shinzo Abe, who is also maintaining pressure on the Bank of Japan to keep interest rates near zero and flood the economy with money to support Japanese manufacturers. As a result, the yen has lost about 15 percent of its value against the dollar over the last three months, meaning products made in Japan, like some Sony electronics or models of Toyota cars, are relatively cheaper.

Japan’s maneuver touched off fears that other countries and the European Union might follow suit in a so-called currency war, which has been the main topic of the Group of 20 meeting here, which runs through Saturday.

Initially, it seemed the world’s largest economies might agree on a firm statement at the end of the meeting to condemn a currency war, or competitive devaluations. This tactic is now widely seen as a beggar-thy-neighbor approach to creating growth that would ultimately harm a global recovery and is understood to be a cause of the lingering nature of the depression in the 1930s.

This is likely to drive a further wedge between the Fed's and the ECB's policy, while angering many politicians in Europe. Through his statements at the G20 meeting, Bernanke in effect just gave his nod to the continuation of the currency war.

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From our sponsor:

The assertion that Romney will change the course of Fed's policy is nonsense

IFR: - Romney’s intention to not re-appoint Fed Chairman Ben Bernanke when his term runs out in 2014 could upset the supportive backdrop for risk assets that has resulted from ongoing quantitative easing, noted Barclays strategists Maneesh Deshpande and Rajiv Setia.

“Given how deeply the ‘Fed on hold till 2014’ view is entrenched into the market, any re-pricing of this probability could have significant repercussions”.

The assumption that a new Fed Chairman under Romney would be more hawkish and less accommodating to markets would provide additional headwinds against economic growth. The market has already started pricing in an expected change to Fed policy at the end of 2014, with the expected Fed funds rate for December 2015 rising roughly 20bp since Romney’s performance in the first debate on October 3.

This assertion is nonsense - IFR needs to do their homework. And given the resources the publication has it is surprising they haven't. First of all it is not even clear if Romney is actually going to replace Bernanke with a hawk or if this is simply part of the campaign rhetoric to grab the Ron Paul supporters' vote.

DB: - Governor Romney’s criticism of monetary policy could have simply been campaign rhetoric intended to win over more conservative voters during the primary season. Governor Romney, in the end, might prove that he has campaigned to the more partisan elements of his party base, but would govern as more of a centrist. ... given the governor’s markets background, if elected he might temper any call for abrupt policy changes to avoid potential negative reactions from risk markets and knock-on effects on household or corporate savings or investment behavior.

Furthermore, the removal of Bernanke will have little impact on Fed's policy - even if the new chairman is a hawk, like John Taylor for example (see discussion). Below is the 2014 FOMC lineup and a rating from DB. A score of 1 indicates an ultra-dovish member and a 5 - an ultra-hawkish one. Even by replacing Bernanke with someone that has a rating of 5 does not create a hawkish majority among the voting members.

DB: - ... given the rotation of voting seats amongst the regional Fed presidents, and presuming that the Board of Governors maintains its current members, even if Bernanke were to leave in January 2014, it appears to be a stretch to presume that a majority could be crafted that was sufficiently to materially change policy, given current fundamentals.

Source: DB

IFR is simply wrong in this assessment - the risk of the Fed shifting policy due to the outcome of this election is minimal (whether we like it or not).

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Fed's unemployment target is unrealistic

The Fed's goals for the US longer term unemployment levels are simply unrealistic and will force the central bank to prolong its easing programs beyond what is really needed for economic growth. This misguided approach will be damaging to the economic growth in years to come.  Here is what the FOMC is projecting for the "longer run" unemployment - a rate that is in the 5%-6% range.

Source: Credit Suisse

As discussed in this post, the Beveridge curve clearly shows that the US had a structural shift in employment dynamics after the financial crisis. What was considered the "equilibrium" unemployment (also called "natural" unemployment) rate needs to be adjusted upward. A more realistic unemployment goal should be in the 6%-7% range, a much more achievable target.

Robert Gordon from Northwestern (via Market Watch): -  “I think more realistically that, gradually, [unemployment] equilibrium will move from 5% to 7%,” he said. He says that fits with anecdotes of businesses finding difficulty in hiring workers with the right skills, and with skills eroding from the long-term unemployed.

When Ben Bernanke referred to current unemployment picture (at Jackson Hole) as "a grave concern" that causes great suffering, he was right. But unfortunately that is the "new normal" and the Fed simply won't be able to push the unemployment rate materially lower than this new equilibrium level. However it may end up doing a great deal of damage while trying.

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Damage from possible QE3 has already started

Those (including some of the dovish members of the FOMC) who still think that the policy of a new round of asset purchases is a low risk proposition should only take a look at US gasoline futures. They hit a multi-year high within the past couple of hours (Sunday night).

Nearby gasoline futures (Bloomberg)

Some are blaming this on the Tropical Storm Isaac, others on the Amuay plant explosion in Venezuela. The reality however is that these price increases are for the most part in anticipation of QE3:

Bloomberg: - Bernanke Boosts Oil Bulls to Highest Since May: Energy Markets

By Asjylyn Loder Aug. 27 (Bloomberg) -- Hedge funds raised bullish bets on oil to a three-month high on signs that Federal Reserve Chairman Ben S. Bernanke will take measures to bolster U.S. economic growth and spur a rally in commodities.

Money managers increased net-long positions, or wagers on rising prices, by 18 percent in the seven days ended Aug. 21, according to the Commodity Futures Trading Commission’s Commitments of Traders report on Aug. 24. They were at the highest level since the week ended May 1.

Let's not pretend that central bank asset purchases and commodity prices are unrelated as some have suggested. QE3 carries with it risks of a spike in headline inflation that will end up damaging an already fragile consumer sentiment and completely negating any positive effects from additional liquidity. In fact the damage to the economy from elevated fuel prices has already started.

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Those believing the Fed is on hold for the next 3 years will be in for a rude awakening

Misconceptions still persist that the Fed is on hold with respect to rates until at least late 2014.

WSJ (Feb 16th): ... They said after their last meeting in January they expect to keep rates at "exceptionally" low levels until late 2014.

The markets would disagree. The Fed Funds futures have the first rate hike (25bp) centered around August of next year and the second hike (to 50bp) on July of 2014.

Fed Funds Futures (implied rate) expected rate hike dates

The market has completely reversed the Fed's announcement on January 25th. In fact the expectations for the first hike are now even earlier than they were before the Fed's statement.

Fed Funds Futures  (implied rate) expectations of rate hike shifted to an earlier date than was priced in before the Fed's announcement

The market is fully ignoring the FOMC's prolonged zero rate forecast. If Bernanke tried to lower short-term rate expectations by the announcement, he failed miserably (though it's possible that was not his intent), as the rate expectations are now even higher than prior to the announcement. Why is the market pricing in higher short-term rates (an early rate hike)? The answer has to do with relatively strong economic data coming out of the US and rising commodity prices. All of this is driving up inflation expectations. The chart below shows TIPS implied 2-year forward inflation expectation now comfortably above 2%, the Fed's inflation target.

TIPS implied 2-year forward (breakeven) inflation expectation

The market is prepared for the first rate hike in about 16 months, possibly sooner. Those who are becoming complacent believing the Fed is on hold for the next 3 years will be in for a rude awakening.

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Bernanke's next steps

Let's take a quick look at options currently available to the Fed and their potential next steps. With the dollar under pressure and bank reserves at historical highs, one would think the Fed is getting uneasy with all the liquidity in the system. Now that the short-term liquidity facilities are winding down, much of the new securities purchases will increase the balance sheet and grow the money supply. Many beleive this will surely lead to inflation.

To address this, the Fed has the following two tools (outside of outright securities sales):

1. Purchase new securities (RMBS, Agency paper, etc.) on repo (sterilized purchases). The Fed would effectively buy the securities and immediately lend them out for some period, taking in cash collateral. This takes these securities out of the market, but does not increase the money supply because the proceeds from these sales would not be available to the dealers (the proceeds become the cash collateral). This could be done not only with new purchases, but with securities already on Fed's balance sheet (about $1.5 trillion worth). To accomplish this on a scale that makes a difference, the Fed needs to set up repo lines with banks and dealers outside of the Primary Dealer group. The primary dealers may not have the capital to absorb such massive amounts of repo transactions on their own.

2. The Fed could also raise rates. But this wouldn't be simply raising the Fed Funds Target Rate. Instead the Fed now has the ability to raise interest rate on the reserves that banks keep with the Fed. That immediately creates a floor on rates because banks have no incentive of lending at levels at or below the reserve rate. Instead they can simply deposit the funds with the Fed on a riskless basis. This tool has been used by other central banks for decades.

The first tool may be set up relatively soon, particularly for new purchases, but it's usage should be fairly modest in the near-term. The rate increases however are months away. Here are two reasons for the Fed's dovish approach:

1. The Fed will not take any rate action until they see improvement in employment. And as we discussed earlier, this may take a while. This is particularly true because many recent jobs (the "bubble jobs") were created on the back of construction spending.

2. The Fed (among numerous measures available to them) watches one key indicator quite closely: the rate of change in "broad" money supply relative to the "narrow" money supply. It's a measure of how effective the liquidity injections have been in stimulating lending. Banks can be loaded with cash, but if they don't lend, the cash is not making it's way into the broader money supply (the banks effectively stay overcapitalized). And that means the broader economy is not benefiting from the liquidity the Fed had provided, which limits it's growth. The chart below shows the relative growth of M1 (narrow measure) and M2 (broader measure). Until M2 picks up significantly, the Fed will do very little in terms of tightening.


source: St. Louis Fed


Inflation is unlikely to pick up until credit is available in the broader economy to allow corporations and individuals to pay higher prices. With broader money supply responding this slowly, significant price and wage increases are unlikely in the near-term.

The possibility of the Fed actually selling securities from it's balance sheet outright is even less likely. Such sales may impact long-term rates, which may have a negative effect on housing and the consumer, and the Fed will categorically not go there. The RMBS securities, the agency paper, and even treasuries they have bought, will stay on Fed's balance sheet for years to come, possibly to maturity.