Next Fed chairman must focus on price stability
Philipp Hildebrand
July 19, 2013
At a Washington press conference earlier this year, a journalist quizzed the Federal Reserve chairman Ben Bernanke about his future role as the US central bank’s exit from its current, unprecedented, monetary policy stance. As you would expect, Mr Bernanke gave away little, but he did make it clear that he felt he was not the only person who could manage that exit.
A credible field of candidates has indeed emerged, should Mr Bernanke choose to step down as expected in January. One thing is clear already: whoever they turn out to be, the chairman – or chairwoman – of the Fed over the coming years will be judged, above all else, on how successfully they manage to steer monetary policy back to something resembling normality.
To state the obvious, the Fed is currently in uncharted waters. The Fed funds rate has been effectively at zero since late 2008. Its balance sheet has quadrupled in size over the same period, to more than a fifth of annual gross domestic product.
Those policies have been justified – Mr Bernanke and his colleagues should be commended for having steered the US economy away from the abyss, and engineered what looks like an increasingly promising recovery. But there is no historical precedent, no rule book and no econometric model that can serve as a reliable guide to how monetary conditions should be normalised.
The recent volatility in markets – in which rates on US 10-year bonds rose by more than 50 basis points over a month, even while quantitative easing 3 continued – only serves to demonstrate how sharp market reactions to the withdrawal of stimulus may be. The chairman will need to navigate those waters while steadfastly protecting the Fed’s independence, and safeguarding its commitment to price stability.
These new challenges may perhaps be a little less dramatic than the recent years of crisis management. The role may even be a little less high profile. But it will be no less important and certainly no less intellectually challenging for whoever is in the chair. Long-term interest rates rose sharply when policy makers simply began to discuss more openly the conditions under which asset purchases would no longer be necessary. Lurking in the background is the possibility of even sharper rises in bond yields as the Fed initiates the policy transition. Memories of the 1994 bond market rout inevitably surface.
In reality, parallels with 1994 are flawed – most obviously because of the enormous changes in Fed communication since then. It is worth recalling that two decades ago the Fed had only just begun to issue formal statements when changing interest rates. The evolution in communication has been extraordinary, with the Federal Open Market Committee now setting out explicit thresholds that economic variables will probably have to reach before monetary policy will be adjusted.
In principle, this new transparency paradigm should much reduce the likelihood of the kind of “surprise” shift in policy that left such deep impressions on bond investors almost 20 years ago.
Nonetheless, there are bound to be pitfalls and challenges along the way as monetary policy is steered back to more familiar territory. And so the choice of chairman over this period needs to be made with these new challenges in mind. Accordingly, two particular attributes stand out that the successful candidate will need to have.
First, the new chairman will need to have – or will need to develop – a firm grip on the theory and practice of how the expansion and shrinkage of a central bank’s balance sheet affects the economy. Questions such as how to get maximum economic benefit from the use of the balance sheet, while minimising the associated risks, were relatively unfamiliar only five years ago. They are crucial now.
Fortunately, the Fed and the central banking community more generally is now well-stocked with staff and management who have been grappling with these issues for several years. Moreover, future decisions on how to shrink the balance sheet will hopefully not need to be made quite at the pace of the decisions to expand it. In other words, there will be a little time for any new chairman to discuss and to learn.
The second and arguably much more important attribute of any new chairman will be the ability and determination to safeguard the Fed’s anti-inflation credibility. That credibility, so hard-won by Paul Volcker in the 1980s, enabled the Fed to take the radical measures of the past five years to boost the economy without suffering damaging volatility in market interest rates. Maintaining and safeguarding it will be critical. More than ever, price stability, and solidly anchored expectations of price stability, will be essential for macroeconomic stability.
Therefore Mr Bernanke’s successor must bring to the job rock-solid credentials as someone who will be a central banker committed to price stability. There must be no doubt in the minds of those in company boardrooms, on trading floors and on main street that whatever else happens, the Fed will keep inflation low and stable. That credibility allowed the Fed to be more aggressive in fighting the crisis, and it will make the job of normalising its monetary policy much easier and much less risky.
The writer is vice-chairman of BlackRock and a member of the company’s global executive committee. Previously he served as chairman of the governing board of the Swiss National Bank and was a member of the Financial Stability Board
A credible field of candidates has indeed emerged, should Mr Bernanke choose to step down as expected in January. One thing is clear already: whoever they turn out to be, the chairman – or chairwoman – of the Fed over the coming years will be judged, above all else, on how successfully they manage to steer monetary policy back to something resembling normality.
To state the obvious, the Fed is currently in uncharted waters. The Fed funds rate has been effectively at zero since late 2008. Its balance sheet has quadrupled in size over the same period, to more than a fifth of annual gross domestic product.
Those policies have been justified – Mr Bernanke and his colleagues should be commended for having steered the US economy away from the abyss, and engineered what looks like an increasingly promising recovery. But there is no historical precedent, no rule book and no econometric model that can serve as a reliable guide to how monetary conditions should be normalised.
The recent volatility in markets – in which rates on US 10-year bonds rose by more than 50 basis points over a month, even while quantitative easing 3 continued – only serves to demonstrate how sharp market reactions to the withdrawal of stimulus may be. The chairman will need to navigate those waters while steadfastly protecting the Fed’s independence, and safeguarding its commitment to price stability.
These new challenges may perhaps be a little less dramatic than the recent years of crisis management. The role may even be a little less high profile. But it will be no less important and certainly no less intellectually challenging for whoever is in the chair. Long-term interest rates rose sharply when policy makers simply began to discuss more openly the conditions under which asset purchases would no longer be necessary. Lurking in the background is the possibility of even sharper rises in bond yields as the Fed initiates the policy transition. Memories of the 1994 bond market rout inevitably surface.
In reality, parallels with 1994 are flawed – most obviously because of the enormous changes in Fed communication since then. It is worth recalling that two decades ago the Fed had only just begun to issue formal statements when changing interest rates. The evolution in communication has been extraordinary, with the Federal Open Market Committee now setting out explicit thresholds that economic variables will probably have to reach before monetary policy will be adjusted.
In principle, this new transparency paradigm should much reduce the likelihood of the kind of “surprise” shift in policy that left such deep impressions on bond investors almost 20 years ago.
Nonetheless, there are bound to be pitfalls and challenges along the way as monetary policy is steered back to more familiar territory. And so the choice of chairman over this period needs to be made with these new challenges in mind. Accordingly, two particular attributes stand out that the successful candidate will need to have.
First, the new chairman will need to have – or will need to develop – a firm grip on the theory and practice of how the expansion and shrinkage of a central bank’s balance sheet affects the economy. Questions such as how to get maximum economic benefit from the use of the balance sheet, while minimising the associated risks, were relatively unfamiliar only five years ago. They are crucial now.
Fortunately, the Fed and the central banking community more generally is now well-stocked with staff and management who have been grappling with these issues for several years. Moreover, future decisions on how to shrink the balance sheet will hopefully not need to be made quite at the pace of the decisions to expand it. In other words, there will be a little time for any new chairman to discuss and to learn.
The second and arguably much more important attribute of any new chairman will be the ability and determination to safeguard the Fed’s anti-inflation credibility. That credibility, so hard-won by Paul Volcker in the 1980s, enabled the Fed to take the radical measures of the past five years to boost the economy without suffering damaging volatility in market interest rates. Maintaining and safeguarding it will be critical. More than ever, price stability, and solidly anchored expectations of price stability, will be essential for macroeconomic stability.
Therefore Mr Bernanke’s successor must bring to the job rock-solid credentials as someone who will be a central banker committed to price stability. There must be no doubt in the minds of those in company boardrooms, on trading floors and on main street that whatever else happens, the Fed will keep inflation low and stable. That credibility allowed the Fed to be more aggressive in fighting the crisis, and it will make the job of normalising its monetary policy much easier and much less risky.
The writer is vice-chairman of BlackRock and a member of the company’s global executive committee. Previously he served as chairman of the governing board of the Swiss National Bank and was a member of the Financial Stability Board
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