Janet Yellen: What the Fed has learned since the financial crisis
Former Fed Chair Janet Yellen has been getting kudos from many corners of Wall Street for her deft handling of the central bank’s path to normalization after the harrowing period during the financial crisis when the august body took extraordinary measures to rescue the U.S. economy and prevent a domino-style collapse of the banking system.
But in an interview this week at a Wharton lecture series, her first public appearance outside Washington since stepping down last month, Yellen reflected on some of the missteps by the Fed as well as financial regulators around the globe for not foreseeing or preventing the 2008 crisis from unfolding. Some critics blamed former Fed Chair Alan Greenspan’s low interest rate policies for fueling the subprime housing collapse that led to the crisis.
Wharton finance professor Jeremy Siegel, who interviewed Yellen, also pointed out that in the book, The Fabulous Decade: Macroeconomic Lessons from the 1990s, she and co-author Alan Blinder nominated Greenspan as the “greatest fine-tuner in history” as he had the rare combination of both skill and luck when managing the economy. However, they wrote that perhaps his luck had run out. “Certainly, his not foreseeing the financial crisis, or giving warnings to it, certainly besmirched that notion that he had an all-seeing eye on the economy?”
Yellen wouldn’t lay the charge solely at the feet of Greenspan. “Greenspan was not alone in this,” she told Siegel. “He and we [Ben Bernanke and herself] had too much faith in financial firms to manage their risks in financial markets, to appropriately price risks in derivatives in the role that they would play.
“I think there was great confidence at the time that derivatives were serving to distribute risk to those who could best understand and bear the risk, and that financial firms understood the risks they were taking and had appropriate incentives to manage them,” Yellen continued. “The financial crisis showed that all of that confidence was misplaced, and supervision of the largest financial institutions was not what it should have been.”
Since the crisis, Yellen said, the Fed and regulators around the world have worked hard to strengthen their supervision, deploying tools such as stress tests and “forward-looking measures of capital adequacy that I think give us much better insight into the risks of the financial system.”
But until recently, the Fed has not had a broad-based program to monitor the entire financial system for emerging threats, Yellen said. In the crisis, she noted, threats came from the “shadow banking system,” those outside the core banking system including money market firms, investment banks, mortgage markets and securitization markets. “That was another failure, not only at the Fed, but of financial regulators as a whole.”
The financial crisis erupted two years after Greenspan retired. His successor, Bernanke, engineered the financial system rescue by taking the Fed to places it has not gone before — moving the Fed Funds rate target to near zero; initiating quantitative easing by buying Treasury bonds and toxic mortgage-backed securities from struggling banks, which ballooned the Fed’s balance sheet more than four-fold to $4.5 trillion; and paying interest on bank reserves to help reach its Fed Funds rate target.
“The financial crisis showed that … confidence was misplaced, and supervision of the largest financial institutions was not what it should have been.”
Yellen, who took office in 2014 after the economy was out of danger, presided over bringing the Fed back to normalcy without roiling the markets or destabilizing the financial system. Under her leadership, the Fed began raising its interest rate target range, which now stands at 1.25% to 1.50%. Last fall, the Fed began the process of whittling down the non-traditional assets it has on its balance sheet. Throughout the process, Yellen communicated the Fed’s intentions clearly in advance, so the markets would not be taken by surprise. Allianz chief economic advisor Mohamed El-Erian called her moves a “beautiful normalization.”
No Uptick in Productivity
Yellen said the new Fed chair, Jerome Powell, faces a “highly favorable” economy with unemployment at a 17-year low of 4.1% and inflation running just under the Fed’s target of 2%. Wages are rising at a “moderate rate,” but that’s not overheating the economy, she said. However, Powell has to keep the economy humming smoothly by hiking rates gradually to keep inflation from getting out of hand, but not so much as to usher in another recession. “There are risks on both sides,” she said.
According to Yellen, the Fed is projecting inflation will move up to 2% over the next year or two, but recognizes that in the past six to seven years it has stayed under the target. “It’s important to make sure inflation does move back up to the Fed’s 2% objective,” she said. Low inflation tends to foster low interest rates. So when the next crisis comes, the Fed will have even less room to lower rates to fight it. Powell has to ensure the Fed strives to meet its twin objectives of maximum employment and 2% inflation, or its interpretation of price stability, Yellen added.
Right now, the labor market is running a little hot and could spark fears of inflation and cause the Fed to raise rates high enough to risk a recession. Siegel pointed out that in February, the economy added more than 300,000 jobs and it brought in 200,000 jobs in January. He asked, “How can we bring that down to a rate that’s long-term sustainable even if there is a little bit of a slack there?” Yellen said that 90,000 to 120,000 new jobs a month would be more sustainable. “But 190,000 a month over the last year, if it continues at that pace, the unemployment rate would gradually fall.” Still, she doesn’t see a “dramatic” rise in inflation.
Yellen noted that today’s environment of low inflation and low unemployment was similar to the period under Greenspan, except for one thing: productivity growth. “He had tremendous insight into what was happening with productivity and deserves great credit for seeing that productivity was picking up in the second half of the 1990s,” Yellen said. “We’re seeing the same thing … [but] we don’t have productivity growth to thank for that.”
Siegel said that in her book about the 1990s, one of the “remarkable factors” was the “surge of productivity growth, particularly in the second half of this decade.” Following the financial crisis, while there is much to be admired about how quickly the jobless rate came down, “what has been extremely disappointing in this recovery has been productivity growth,” he said. “We economists seem to be having a hard time understanding why productivity has lagged so much. It’s a major reason why wages have stagnated,” among other reasons.
“It’s hard to tell,” Yellen said. “Some believe it’s the pace of innovation.” However, current innovations are not yielding payoffs on par with those seen in the early 20th century, like the discovery of electricity. It’s not due to the crisis, she said, because productivity was slowing even beforehand and it is happening globally. “That suggests something structural as opposed to crisis-related.” She doesn’t think it’s a measurement error, either. And Yellen predicts productivity will stay down. “I don’t have a good reason to believe the future will be different.”
‘Elevated’ Asset Prices
Another risk that Powell, who is presiding over his first Federal Open Market Committee meeting this week as chairman, should monitor are asset prices such as in stocks and commercial real estate that are “probably elevated,” Yellen said. Siegel noted that at one point she also said stocks weren’t overvalued. She clarified her position, saying “I don’t know what the right level of asset prices is.” However, Yellen noted that stock values today are higher based on historical trends. “It’s true, interest rates are low so it’s one reason to expect higher price-to-earnings multiples, but perhaps they’re still high given the level of interest rates. That is something that ought to be on the list of risks to the economy.”
There’s some good news, however. “The financial system seems to be sound,” Yellen said. “We’re not seeing evidence of growing leverage. … The systemically important banks are very well capitalized and are strong. Supervision has strengthened immeasurably since the crisis.” Her assessment of current conditions? “Risk is moderate,” but the Fed should monitor it.
“The systemically important banks are very well capitalized and are strong. Supervision has strengthened immeasurably since the crisis.”
Asked whether the whittling down of the Fed’s non-traditional assets to more historically normal levels would spook the markets, Yellen said that the changes it is making are “gradual and predictable” so as not to cause much turmoil. It was well communicated so that “by the time it began, it was very well understood.” The Fed was not actually selling the assets it bought during the crisis, she noted. Rather, when it receives principal payments from Treasury bonds or mortgage-backed securities, it does not reinvest the funds into new securities.
Yellen said the goal of buying those assets was to put downward pressure on long-term interest rates. Therefore, as the Fed unwinds the assets there would be some upward pressure on those rates. “But it would be gradual, too,” she said. Moreover, the unwinding would take the balance sheet to about $2 trillion to $3 trillion, not back to pre-crisis levels.
Wells Fargo and Cryptocurrencies
The Fed, under Yellen, did do something unusual when it came to bank supervision of Wells Fargo. It put curbs on the bank’s expansion until it could prove that adequate risk controls were in place. “Although the cap on its asset growth was unusual, it was deemed appropriate given Wells Fargo’s size” and the scope of its shortcomings, she said. The Fed could repeat such sanctions in the future since that is part of its tools to ensure adequate risk management. “That type of thing could be employed again.”
As for cryptocurrencies, Yellen said the Fed has looked at the possibility of creating its own digital currency. “Many central banks around the world are studying that possibility,” with the Bank of Sweden going further than others, she said. However, “the general view in the central banking [community] is that this is something we should be very cautious about. It could lead to very far-reaching changes in the structure of financial intermediation in the U.S. and other countries with a variety of consequences that might not be favorable ones.”
Moreover, “it’s not obvious that it would do anything at all to enhance monetary policy control,” she continued. “We’ve long thought that the use of cash would diminish over time. That’s actually not shown to be the case. U.S. dollar currency is alive and well, and demand for it has been growing at a rapid rate. So I’m not aware of any enthusiasm at this point on the part of the most advanced countries’ central banks to introduce their own digital currency at the retail level.”
Asked about the impact of the proposed tariffs on steel and aluminum, Yellen said the Fed stays away from giving advice on fiscal policy. However, trade policy does affect the economy. “Generally, the tariffs that have been recently announced will have a tiny impact on inflation,” she said. While there would be some price increases, “overall, when you work the numbers, it’s relatively little. … The impact of what’s been announced is not very large.” But the bigger concern is if the trade wars expand and whether other nations will retaliate against the U.S., she added.
Love at First Sight
After leaving the Fed, Yellen headed for the Brookings Institution in Washington where she is the new distinguished fellow in residence at the think tank. “I have not yet taken a vacation,” she revealed. Her Brookings colleagues include Bernanke and former Fed vice chair Don Kohn. She joked that they have been dubbed the new FOMC, or Former Open Market Committee.
Adopting digital currencies “could lead to very far-reaching changes in the structure of financial intermediation in the U.S. and other countries with a variety of consequences that might not be favorable ones.”
Now that Yellen is no longer in the hot seat as Fed chair, a job that she said was an “honor and a privilege,” it also was a “relief” in some ways to have more independence. Yellen said she used to have a security detail following her around. “There was a little bit of a feeling of being in jail,” she said. “I do have a newfound sense of freedom and independence.” Another thing she didn’t miss was the “high degree of stress” associated with the job.
Her path to the top of the Federal Reserve started with an interest in economics early on. “I didn’t really know much about economics in high school,” Yellen said. After taking a class in economics while at Brown University, she was hooked. “That was really love at first sight.” She loved the rigorous math and analytical thinking involved but also that economics influenced human welfare. “That combination really appealed to me.” It let her use analytical skills but also “contemplate questions that were first order of importance to society.”
Throughout her career, Yellen was often one of very few women in economics. Indeed, she is the first female chair of the Federal Reserve. Did she face discrimination? “Discrimination does exist,” she said. However, “my own experience has been very favorable. I can’t say that I have ever experienced overt discrimination because of being a woman.”
She said she had several male mentors who guided her, including Nobel laureate James Tobin and her husband, George Akerlof, another Nobel winner. Besides barriers to advancement, perhaps women could not find enough role models in economics to encourage them to seek those jobs. That must change. “It’s important for the economics field to be more diverse,” she said.