Janet Yellen’s moment
When Janet Yellen chairs her first meeting of the Federal Open Market Committee Tuesday and Wednesday, she will be presented with a once-in-a-generation opportunity that even her predecessors in the world’s most powerful economic position have rarely enjoyed.
Not only can Yellen alter the guidance on interest rates with which the FOMC has been steering global financial markets. Beyond that she could do something far more profound and exciting: transform an entire generation’s way of thinking about economics, market forces and the role of government in achieving and maintaining prosperity.
To start with the obvious, Yellen will almost certainly change or simply abolish the unemployment “threshold” of 6.5 percent announced early last year as a reference point for the FOMC to start considering the possibility of higher interest rates — perhaps setting a threshold of 5 percent or so. More radically, she could supplement the objective of lower unemployment with a range of other indicators that will need to improve before the Federal Reserve even considers any monetary tightening: for example, accelerating gross domestic product growth; strengthening productivity trends and eliminating the excess capacity in many industries that is now discouraging investment, hiring and productivity growth, as well as holding down corporate pricing power.
This potential broadening of the range of monetary objectives suggests the really radical possibilities opened up by Yellen’s leadership of the Fed. Might she announce, for example, that as the economy recovers, the Fed will ignore accelerating inflation and focus entirely on promoting maximum employment, unless and until inflation exceeds some truly uncomfortable level such as 3 or 4 percent? Will she follow up on some of the work done within the Fed, suggesting that expansionary monetary policy can act not just as a cyclical stimulus, but could also improve supply-side conditions and long-term productivity growth?
Might she even suggest that, if the economy requires further monetary stimulus in future, Quantitative Easing could be coordinated with fiscal policy? For example, the Fed could print “helicopter money” for the government to “drop” directly on to the public via citizen dividends or per capita tax rebates.
To understand why the Ben Bernanke-Yellen transition could be so significant requires a brief detour into economic theory and history. In contrast to Bernanke, who was a lifelong apostle of monetarism and of Milton Friedman, Yellen has a Keynesian academic background. This may not be significant in terms of policy — since Bernanke already ventured far beyond traditional monetarist central banking — but the theoretical distinction could transform the Fed’s understanding of what it is doing and why.
In the five years since the 2008 financial crisis, central banks all over the world have, reluctantly and cautiously, begun an intellectual revolution. The failure of traditional economic theory to anticipate or explain the crisis — and the even more remarkable failure of traditional models and policies to chart the way back to normal economic conditions — has forced central bankers to re-examine some of the most fundamental tenets of modern economic theory. In the process they have started to question some of their core beliefs about the social purpose of central banking. These beliefs were always just theoretical hypotheses and assumptions, but were transformed into unquestionable dogmas by the great inflation of the 1970s and the resulting monetarist “counter-revolution” against Keynesian economics.
Three of these fundamental assumptions about monetary policy, and about government macroeconomic management more generally, have gradually been re-opening for debate around the world: First, that high inflation is the only monetary obstacle to satisfactory economic growth and employment — and therefore that controlling inflation is the sole legitimate long-run objective of monetary policy. Second, that political independence of central banks from governments must be protected at all costs — and therefore monetary policy must be managed separately from fiscal policy. Third, that monetary policy can have no permanent influence on an economy’s underlying productivity growth, employment levels or other “supply-side” conditions — and therefore a central bank has no role to play in a nation’s efforts to accelerate long-term economic growth, apart from maintaining price stability.
All these assertions about monetary policy were accepted in the 20 years before the 2008 crisis as scientifically-established laws of nature, because it was possible to invent theoretical models from which they could mathematically be derived. But neither the assumptions that produced these models, nor the conclusions they generated were supported by strong evidence from the real world.
For example, one key empirical “fact” that justified the 1980s consensus in favor of inflation targeting and independent central banks was an observation by Milton Friedman in the late 1960s, which supposedly proved that the “trade-off” between inflation and unemployment previously assumed by central bankers did not exist.
But Friedman’s empirical discovery, known as the “vertical Phillips curve,” supposedly showing that widely varying levels of inflation coincided with a single natural level of unemployment, subsequently turned out to be completely wrong. Actually, the U.S. Phillips curve was only vertical for five years from 1964 to 1969. Then, after a period of monetary turbulence in the 1970s, the Phillips curve became almost exactly horizontal from 1982 to 2013 — completely refuting the original conjecture.
Yet despite such empirical falsification, central bankers worldwide continued to behave as if Phillips curves were vertical. Even when they were forced to act far more radically after the crisis, they continued to justify and explain their policies as if they were still pursuing the orthodox objective of price stability — rather than trying to create employment and accelerate economic growth.
Which brings us back to the Yellen Fed. The orthodox monetary economics of the 1980s and 1990s clearly failed and highly-respected institutions such as the International Monetary Fund and the Bank of England have sometimes hinted at the need for a root and branch reconsideration of both the methods and the objectives of monetary policy. But only the Fed has the power and the intellectual credibility to overturn the totems of failed monetarism and start the search for a new and better understanding of macroeconomic policy.
Over to you, Professor Yellen.
PHOTOS: Federal Reserve Chair Janet Yellen testifies before a House Financial Services Committee hearing on “Monetary Policy and the State of the Economy.” at the Rayburn House Office Building in Washington, February 11, 2014. REUTERS/Mary F. Calvert