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11 28 2015 | by Victor Xing | Central Banks
What is FED Chair Yellen’s monetary policy?
FED Chair Yellen – the Keynesian policymaker
Chair Yellen is a Keynesian policymaker who is willing to look past traditional monetary policy rules in her mission to meet the FED’s dual mandate. When the U-3 unemployment rate suggested that the economy was approaching full employment, Chair Yellen held her ground and directed market participants to look at broader economic indicators for signs of labor market slack (please see:).
Focus on financial conditions
Yellen expanded former FED Chair Bernanke’s initiative to improve the FED’s communication. In her view, better communication to financial market participants can help guide investor expectations and avoid averse market conditions seen during the “Taper Tantrum.” Amongst FED officials, Chair Yellen and New York Fed President Dudley are strong advocates of using FED communication tools (in addition to actual monetary policy tools) to affect borrowing costs. In effect, profit-seeking financial market participants would follow FED’s communication and tighten or loosen(bond yields, credit spreads, equity prices) to help guide economic conditions toward FED’s monetary policy objectives.
President Dudley famously said the following in his December 2014 speech::
If the linkage from the federal funds rate to financial market conditions were stable over time, there would be no need to focus on financial market conditions. In a world in which the linkage was solid and unchanging, adjustments to the short-term interest rate and communication about future policy would have a predictable and reliable effect on financial market conditions. Central bankers, then, could keep their focus narrowly on their policy rate.
However, as has been very clear, especially in recent years, this linkage is not stable. Thus, how much one pushes on the short-term interest rate lever depends, in part, on how financial market conditions respond to such adjustments. Imagine driving a car where the connection between the gas pedal and the engine speed was variable and uncertain. The driver would have to constantly monitor and adjust the pressure on the gas pedal to achieve the desired speed. Similarly, we will have to monitor and adjust short-term interest rates to achieve financial market conditions consistent with achieving our labor market and inflation objectives. All else equal, less responsiveness implies larger interest rate adjustments and vice versa.
Quickly, let me give two examples that illustrate how variable this linkage can be. First, during the 2004-07 period, the FOMC tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten.
As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Second, during the financial crisis, especially during the fall of 2008, financial market conditions tightened dramatically even as the FOMC was cutting its federal funds rate target to zero. Monetary accommodation turned out to be insufficient to produce an easing of financial market conditions, and the economy fell into a deep recession.
In other words, Yellen, Dudley, as well as other senior policymakers are focusing on effectively managing financial conditions via policy communication channel and FED policy tools (IOER, ON RRP, reinvestment program, and balance sheet operations), so FED policy can be transmitted into the real economy (with a lag) via the financial sector.
Goldman Sachs Financial Conditions Index – now at multi-year tights on policy normalization expectations.
Next article11 28 2015 | by Victor Xing | Central Banks