The US Senate this week confirmed Janet Yellen to replace Ben Bernanke as head of the US Federal Reserve. The Fed, which has just celebrated its 100th birthday, is global HQ as far as the world’s financial markets are concerned. Famously, it employs more economists with PhDs than any other institution on earth.
Yellen herself is a gifted mathematician who is married to a Nobel prize-winning economist – only the usual misogyny of the Nobel committee kept her from sharing the honour.
However, brainpower is not enough to run the Fed successfully. Alan Greenspan, Yellen’s predecessor but one, had a PhD in economics and still managed to ignore the biggest asset bubble since the universe popped out of the vacuum. True, Yellen, age 67, may be more streetwise than the men who came before her.
The analysis of labour markets that won her husband, George Akerlof, his Nobel asks why firms pay higher wages than they need to. Co-author Mrs Akerlof provided the explanation (in maths): she paid the babysitter above the going rate because she wanted to keep their loyalty. This theory of “efficiency wages” explains why UK unemployment did not rise faster during the recession.
As a scientist rather than a free market ideologue, the problem with Yellen is she might end up being too technical. She favours an approach to managing the economy called “optimal control”. This involves using sophisticated mathematical techniques to pre-calculate the “ideal” path of interest rate changes needed to hit inflation and unemployment targets (the Fed has a dual mandate). This means keeping rates low for longer to make unemployment fall, while accepting higher inflation for a period.
The catch is that “optimal control” assumes irrational inflationary psychology never takes hold because everyone trusts the Fed. Some hope. Yellen knows this and argues: “A dose of good judgment will always be essential as well.” Fingers crossed, then.
Yellen is an extreme advocate of forward guidance, or telling the markets what the central bank intends to do well in advance. In theory, this is supposed to engender investor confidence. The idea is also shared by Mark Carney at the Bank of England.
Unfortunately, the forward guidance regime creates its own problems. Markets tend to over-react whenever a member of the interest rate policy board says something in public, taking this as “guidance”. Witness last year’s “taper tantrum” when Ben Bernanke made an obviously true statement that the Federal Reserve would one day have to cut quantitative easing.
Lesson: running a central bank is as much art as science. My gut feeling is that, with less male testosterone at the Fed, Yellen may prove a good thing.
December US jobs figures, out yesterday, proved a conundrum. Analysts were expecting employment to increase by around the monthly average for 2013, at 182,000. The actual number turned out to be a meagre 74,000. However, a sharp decline in the participation rate caused overall unemployment to drop to 6.7 per cent – below the Fed’s target.
Given that data from private payroll companies showed a much larger increase in hiring, the official figures are probably a statistical wobble. With consumer spending, trade and production up, the US economy is set for circa 3 per cent growth this year. But Yellen will need her crystal ball.