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Janet Yellen's Fed
As long as inflation remains low, Janet Yellen will likely advocate a slow exit from the Fed's easy policy stance

by Zach Pandl, Portfolio Manager and Strategist

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Highlights

  • The dove question
  • Labor market takes center stage
  • Inflation targeting continuity
  • Optimal control and forward guidance
  • Bubbles, banks and bonds

Chair of the Federal Reserve Board might be the most powerful job in global finance. This speaks to both the importance of America's central bank, but also to the way the institution functions. The chair has disproportionate influence over monetary policy decisions. Although the Federal Open Market Committee (FOMC) votes at every meeting, the outcome is never in doubt — the chair secures enough support beforehand. Outside the FOMC meetings there appears to be some genuine give and take among members of the board and, to a much lesser extent, the presidents of the regional Fed banks. But these are not debates among equals: the Federal Reserve chair is always in the driver's seat. If Janet Yellen is confirmed, as we expect, her views will weigh heavily on policy decisions for at least the next four years.

The same was true during Chairman Ben Bernanke's tenure: his views on inflation targeting and research on the Great Depression have informed many of the Fed's actions since 2006. But the Bernanke years are also a reminder about the importance of events. Monetary policy and interest rates depend first and foremost on the evolution of the economy. It was helpful to know where Bernanke stood on various policy questions, but only for understanding his reaction to the global financial crisis. Similarly, Yellen's views will be important for understanding the Fed's response to the evolving outlook.

In this essay we discuss Yellen's views on the central questions for monetary policymakers: the labor market, inflation, financial stability and policy strategy. Our conclusions are drawn from FOMC meeting transcripts and Yellen's public speeches as a Federal governor in the 1990s, as president of the Federal Reserve Bank of San Francisco from 2004–2010 and vice chair of the Federal Reserve Board from 2010 through the present (see page 14 for her full bio).

We argue that Yellen should be considered a dovish central banker, relative to other Fed officials and other possible candidates for Fed chair (see The dove question). Many economists dislike the hawk/dove terminology, and we use the label with some reluctance. Nonetheless, it can be a useful shorthand for a complicated subject, and in Yellen's case we think the evidence is reasonably strong. In the current environment, she is more likely to advocate a slower exit from quantitative easing (QE) and a longer period of zero short-term rates, compared with her Fed peers (Exhibit 1).

Exhibit1: Next Fed chair to face challenging exit process:
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Labor markets will likely remain a central focus for the Fed under Yellen (see Labor market takes center stage). She believes unemployment has high costs — both for today's jobless and for the performance of the economy over the longer run. One important question will be how the Yellen Fed addresses the falling labor force participation rate. We expect that she will lean toward a cyclical interpretation for the ongoing decline, and this may lead to communication changes for the FOMC in 2014. She may also discuss a policy strategy known as "optimal control" to emphasize the Fed's commitment to stimulating job growth (see Optimal control and forward guidance).

On the Fed's price stability goal, Yellen supports run-of-the-mill inflation targeting (see Inflation targeting continuity). She was an early adopter of this framework and supported a sub-2% target initially. On inflation questions we see very little daylight between Yellen and Bernanke. Yellen's views on inflation could surprise markets: she would likely tolerate a modest overshoot of the target, but not a sustained miss. Any meaningful pickup in inflation could be an early communication challenge for the next Fed chair.

Yellen's views on the Fed's role in promoting financial stability have not changed much with the crisis (see Bubbles, banks and bonds). Like many central bankers, she appears more attentive to possible bubbles and their risks to the economy. But her "strong preference" is to use macroprudential (regulatory) tools to address financial stability, rather than monetary policy.

For fixed-income investors the Yellen nomination should be read as favorable news. In a recovering economy, rising rates will still be a headwind for bond returns. But we think the Yellen Fed will attempt to keep the process as gradual as possible. We also think Yellen is not as tolerant of inflation as some investors fear (though we can see a case for some additional inflation protection in portfolios). For credit markets, the Yellen Fed could mean a lower cyclical floor for spreads. Where some investors see overheating, she is more likely to see the monetary transmission mechanism at work. Thus, fixed-income total return prospects improve with a Yellen-led Fed.

The dove question

By and large Fed officials agree on their goals for the economy over the longer run. They have all now adopted a formal inflation objective of 2%, and their views on the appropriate unemployment rate fall in a tight range of 5.2% to 6.0%. Where they disagree is on what should happen between now and then: how costly is high unemployment; what are tolerable paths for bringing inflation and unemployment back to normal levels; how aggressively should the Fed work to achieve its goals; and what are the risks to action versus inaction. In our experience, the relative views of individual policymakers on these types of questions line up surprisingly often. This is what is meant by "hawks" and "doves" in central banking: there is a subjective component to policymakers' views that remains pretty constant over time and explains why some officials always seem to be on one side of the debate.

Yellen is a very thoughtful economist. You get the sense reading her speeches and the transcripts of FOMC meetings that she puts a sharper pencil to the issues facing the committee than some of the other members. She also has a consistent analytical framework (grounded in mainstream models and academic research), and seems dedicated to the Fed's statutory mandate — she quotes often from the Federal Reserve Act and the official statement on policy goals and strategy. For these reasons, we are a little uneasy putting a simplistic label on her policy approach.

But just like with other central bankers, we see a subjective component in Yellen's views, which will likely color her decisions as the next Fed chair. And throughout her career, Yellen has mostly fallen on the dovish side of U.S. monetary policy debates. We therefore agree with the general perception that she would be dovish as Fed chair. It's important to say that this characterization is probably overstated in financial markets, likely because of her views in the current economic environment. Still, relative to Bernanke, and relative to the other candidates reportedly considered for Fed chair, we expect that Yellen will lean more often in an accommodative direction.

This argument is backed up both by today's policy debates as well as history. Fed officials are currently divided over a number of questions, and in most cases Yellen's views point to an easier policy stance, relative to the average policymaker. For instance, she downplays the unemployment rate compared with other Fed officials and sees cyclical weakness in the labor force participation rate. She also seems to advocate an aggressive policy approach through her emphasis on "optimal control." Lastly, she has expressed more sanguine views about financial stability risks and is less inclined to use monetary policy to address asset price bubbles.

Regarding Yellen's track record, media reports often point to a story that seems to contradict the widely held perception. Former Fed Governor Laurence Meyer covered the event in detail in his book on the Fed, but the following is a concise description he wrote more recently:1

"The final question is whether Janet is really a dove. Let me tell you a story ... Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings ... Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn't say a word. After an awkward silence, we said our good-byes. Needless to say, we didn't win this argument. Yet, we never dissented."

Yellen and Meyer preferred to raise rates at the September 1996 meeting. They were overruled but chose to vote with Greenspan anyway. This is what Fed watchers call a "shadow dissent": FOMC members will often disagree with the decision but vote for it anyway because of tradition, etiquette and/or considerations about the public reception to the Fed's action. For this reason, shadow dissents are a better indicator than voting records for determining policymakers' biases.

Yellen's shadow dissent at the September 1996 meeting makes an important point: she may not always be on the same side of the debate. But the question is whether this episode is a good guide for her views in general. To find out, we read through all the public FOMC meeting transcripts during Yellen's tenure as a governor and president of the San Francisco Fed and counted her shadow dissents. The record shows that the September 1996 meeting is the exception rather than the rule: she disagreed with the committee decision on five other occasions, and all of these were in favor of an easier policy stance. Here are those examples with her quotes from the transcripts and their page numbers:

  1. November 1994: FOMC increased the funds rate by 75 basis points (bps). Yellen preferred a smaller hike: "I can live with 75 bps today. But on balance ... I would favor 50" (transcript page 41).
  2. January 1995: FOMC increased the funds rate by 50 bps. Yellen preferred no change: "My choice would be to wait" (transcript page 114).
  3. July 1995: FOMC reduced the funds rate by 25 bps. Yellen preferred a larger cut: "My inclination would be if I had my druthers to choose a 50 bps move" (transcript page 71).
  4. June 2006: FOMC increased the funds rate by 25 bps. Yellen argued economic conditions called for a pause: "The option value of pausing ... made it preferable to pause on purely economic grounds today .... In general, I believe that we should do the right thing, even if it surprises markets, but in this case our public statements seem to have convinced the public that we will raise the funds rate today. If we didn't follow through, there would likely be some loss of credibility for policy" (transcripts pages 104–105).
  5. December 2007: FOMC reduced the funds rate by 25 bps. Yellen preferred a larger cut: "I also favor alternative A, a 50 bps rate cut" (transcript page 96).

Labor market takes center stage

When it comes to the current priorities for monetary policy, investors already know where Yellen stands. In her words: "With employment so far from its maximum level and with inflation running below the committee's 2% objective, I believe it's appropriate for progress in the labor market to take center stage in the conduct of monetary policy"2 (Exhibit 2).

Exhibit 2: Labor market still too weak:
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Labor market issues have long taken a central role in Yellen's career. As an academic economist her most well-known research focused on an idea called the "efficiency wage theory," which argues that firms set wages in an effort to promote worker morale and thereby improve productivity. For the economy as a whole this theory helps explain involuntary unemployment, because efficiency considerations move wages away from the market equilibrium. Other papers touched on labor market turnover and the psychological effects of job loss.

Yellen is also unique among policymakers in regularly describing labor market developments in personal terms. For instance, in her confirmation hearing for Fed governor in 1994, Yellen said that she hoped to keep in mind "the people behind the numbers." Similarly, in discussing employment conditions earlier this year, she stressed: "These are not just statistics to me."

Besides this difference in style, however, Yellen's basic framework for relating the labor market to monetary policy has historically remained close to the "New Keynesian" mainstream. This is reflected in the types of models she relies on in her analysis as well as her qualitative descriptions of the Fed's role and objectives. The following quote appeared in a 1995 interview with the Federal Reserve Bank of Minneapolis,3 shortly after Yellen joined the board:

"I would agree that the Fed probably cannot achieve permanent gains in the level of employment by living with higher inflation. But the Federal Reserve can, I think, make a contribution on the employment side by mitigating economic fluctuations — by stabilizing real activity. I thus translate the ‘maximum employment' proviso of the Federal Reserve Act as a mandate for the Fed to lean against the wind, stimulating the economy when the economy is in recession or unemployment is clearly in excess of the NAIRU (the non-accelerating inflation rate of unemployment — the minimum rate of unemployment consistent with stable inflation), and restraining the economy through tighter policy when economic activity is pushing against the limits of capacity with inflationary implications."

This view would be shared by the majority of mainstream macroeconomists today, both in academia and the policy world. Thus, there is nothing special about Yellen's basic model or framework that would dictate a shift in course from the Bernanke-led Fed.

At the moment, however, even mainstream economists are divided over certain labor market questions, and here Yellen falls more obviously to one side. We would highlight three distinguishing features of her current views. First, she consistently argues that elevated unemployment reflects a cyclical shortfall in demand rather than structural changes in the labor market. Second, she worries that long spells of unemployment could make job seekers less employable in the future, which would raise the natural rate of unemployment — an effect known as "hysteresis." Third, Yellen worries about cyclical weakness in the labor force participation rate (LFPR), though we are not sure to what degree. In a nutshell, Yellen views current labor market challenges as potentially very costly for the economy, and she sees a role for monetary policy in promoting recovery.

Yellen's views on the LFPR could prove important to the evolution of policy over the next year. In a speech in March, she argued that high long-term unemployment could lead to "a persistently lower rate of labor force participation" if jobless workers decide to drop out of the labor force. The idea that high long-term unemployment causes the LFPR to fall is a relatively new idea (at least to our knowledge). It was articulated in a widely circulated paper written earlier this year by economists Christopher Erceg and Andrew Levin,4 who also serves as Yellen's de facto chief of staff at the board. The Erceg/Levin hypothesis could have major implications for monetary policy, including the appropriate design of forward guidance. Changes to the Evans Rule5 could be on the way if Yellen embraces this view.

Yellen has been refreshingly transparent about the indicators she will be watching to determine when there has been a "substantial improvement" in the labor market outlook— the condition necessary for ending QE. These are:

  • The unemployment rate
  • Payroll employment growth
  • Gross layoffs and gross hiring
  • The quit rate
  • Overall economic growth

Generally these indicators have been moving in the right direction, although the pace of expansion in both jobs and overall gross domestic product (GDP) has not yet accelerated (Exhibits 3 and 4). We unfortunately do not know precisely what threshold would qualify as satisfactory for each indicator. At the time of the September FOMC meeting, we were presumably still too far from "substantial improvement" for the set of indicators as a whole to begin slowing the pace of QE.

Although Yellen's basic framework is close to the mainstream, she comes down on the cautious side of current labor market debates. Plus, her policy bias generally tends toward the side of greater activism. As a result, Yellen's nomination likely raises the bar for Fed tightening, as long as inflation remains low.

Exhibit 3: Firing down, but hiring still far from normal:
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Exhibit 4: Job growth remains modest by historic standards:
Change in private nonfarm payroll employment
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Inflation targeting continuity

A major question among investors after Yellen's nomination for Fed chair is whether she will be too soft on inflation. Part of Yellen's dovish reputation stems from a debate among the FOMC in July 1996, in which she warned the committee about the risks of pushing inflation too low. With the passage of time, however, the views Yellen expressed at that meeting now come across as very sensible. Indeed, today they would be considered uncontroversial among most economists. In reality Yellen is closer to the Fed consensus on inflation than her reputation in markets would suggest.

The debate at the July 1996 FOMC meeting focused on the appropriate long-run goals for monetary policy. At the time the Fed had a statutory mandate to publish target ranges for monetary aggregates, but in practice they were not used as a guide for policy due to the weak relationship between money growth and inflation. Chairman Greenspan therefore asked the committee to debate how policymakers should interpret and institutionalize the "price stability" mandate of the Federal Reserve Act.

In his opening remarks, Greenspan framed the question as a choice between an inflation target of zero6 and a price level target that remained stable over time. Governor Yellen, however, used her remarks to argue for a positive inflation objective for the FOMC. She made two main arguments: (1) positive inflation was needed to "grease the wheels" of the labor market due to rigidity in nominal wage contracts, and (2) positive inflation makes it easier for the central bank to lower real interest rates and reduces the risk of hitting the zero lower bound. Later in her career Yellen stressed the same two factors, noting that the first had become less important (due to faster productivity growth) but the second more important (due to the experience of prolonged deflation in Japan).7 On net she came out in the same place: the Fed should aim to achieve low positive inflation rather than zero inflation. Today this is the formal mandate of most developed market central banks.

Yellen's dovish reputation on inflation is also belied by her early support of inflation targeting. In early 2006 when Bernanke was about to take over as chairman, Yellen pointed out that he differed from Greenspan in one important way: he favored an explicit inflation target for the Fed.8 Yellen sided with Bernanke and stated on numerous occasions that she favored a target of 1%–2% for the core Personal Consumption Expenditure (PCE) deflator — the midpoint of which was actually below the 2% target the Fed ultimately adopted. She has reiterated her support for inflation targeting as recently as April 2013: "In terms of the targets, or, more generally, the objectives of policy, I see continuity in the abiding importance of a framework of flexible inflation targeting."

On inflation we therefore expect mostly continuity from the Yellen Fed. She supports run-of-the-mill inflation targeting, much like Bernanke (Exhibit 5).

Exhibit 5: Inflation currently below Fed's 2% target:
Consumer price inflation (PCE index)
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A tougher question is how the Yellen Fed would balance its inflation and full employment goals if they came into conflict. We see some room for concern that Yellen would be more tolerant of overshooting the Fed's inflation target, at least for a time, compared with other Fed officials. This is the implication of the optimal control simulations she presented in a series of speeches last year, for example.

She has also made the point that the Fed should err on the side overshooting because it is easier for monetary policymakers to tame inflation than it is to pull the economy out of deflation. Here is Yellen in an April 2012 speech:

"Risk-management considerations strengthen the case for maintaining a highly accommodative policy stance longer than might otherwise be considered appropriate. In particular, the FOMC has considerable latitude to withdraw policy accommodation if the economic recovery were to proceed much faster than expected or if inflation were to come in higher. In contrast, if the recovery faltered or inflation drifted down, the Committee could provide additional stimulus using its unconventional tools, but doing so involves costs and risks. Given the unprecedented nature of the current economic situation and the limits placed on conventional policy by the zero lower bound on interest rates, these issues of risk management take on special importance."

That being said, it is easy to overstate these inflation risks. First, Fed officials have not actually adopted the optimal control framework (see next section), and future inflation considerations are probably a reason for this.

Second, our guess is that an inflation overshoot would cause the FOMC to revise up its estimate of structural unemployment and dial down accommodation.9 We do not think Fed officials would continue with aggressive policies to push unemployment down if inflation picked up meaningfully. As the Fed's statement of long-run goals and objectives makes clear, there's a fundamental difference between the price stability and full employment parts of the mandate. The economy's inflation rate "over the longer run is primarily determined by monetary policy," whereas the level of full employment "largely determined by nonmonetary factors." The Fed does not face a tradeoff between its two goals today: unemployment is too high and inflation is too low. They are complementary objectives.

But if they do come into conflict in the future, a Yellen Fed would likely give precedence to the inflation goal. If our reading of Yellen's views is correct, then inflation becomes a major swing factor for the interest rate outlook.

We think Yellen might tolerate some overshooting of the inflation target, but not a sustained miss. Plus, support for continued QE would likely erode among the rest of the committee with inflation at or above target. Any pickup in inflation could be an early communication challenge for the next Fed chair.

Optimal control and forward guidance

If Yellen is confirmed by the Senate, investors can look forward to hearing more about a monetary policy strategy known as "optimal control." In a series of speeches in 2012, Yellen framed the central bank's policy outlook using optimal control. While the FOMC has not fully embraced an optimal control approach, we believe it has informed much of its public communication over the last year. Understanding optimal control can therefore shed light on policymakers' goals, as well as some of the risks they are taking.

The basic idea behind optimal control is straightforward: the central bank considers all the possible paths for short-term interest rates over the next several years, chooses the best one, and then commits to sticking with that plan over time. This differs from a strategy of deciding policy on a meeting-bymeeting basis, in which the choice is based on current conditions alone.

An analogy could be made to the game of chess. A beginner will decide the best move based on the current configuration of the board, even if her choices might lead to dead ends later in the game. In contrast, an expert player will consider all the future paths that the game could take and then make the sequence of moves that give the best probability of an eventual win. Sometimes this forward-looking strategy will lead to decisions that appear suboptimal over the short-run — i.e., sacrificing a valuable piece to gain an advantage later on.

Optimal control monetary policy works much like this: the central bank commits to a game plan that at times might look misguided, but in theory the strategy should lead to better outcomes for unemployment and inflation. Mechanically, optimal control works by setting a specific "loss function" for the central bank. A loss function is simply a way to express policymakers' objectives ("price stability and full employment") in equation form. Economists then use a model to simulate the performance of the economy under different paths for short-term interest rates. The path that generates the best outcome for the loss function — where inflation and the unemployment rate are closest to their targets over time — is called the optimal control policy.

Exhibit 6: Optimal control calls for longer period of low funds rate:
Federal funds rate
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Today, the optimal control approach argues for a "lower for longer" path for the funds rate than standard Taylor Rules.10 Exhibit 6 shows this comparison using data from Yellen's first optimal control speech in April 2012. The two Taylor Rules are drawn from John Taylor's academic research and are standard rules for monetary policy analysis (though Yellen made a minor adjustment from the original papers). At the time she gave this presentation, the "Taylor 1993" rule prescribed a start to rate hikes in Q4 2013, and the "Taylor 1999" rule called for a first hike in Q1 2015. In contrast, the optimal control rule argued for a first hike in Q1 2016. Optimal control simulations using current economic conditions show a similar lift off date for the funds rate.

Why is the optimal path for the funds rate so low? There are two (related) ways to get the intuition. First, the extended period of a low funds rate makes up for lost time. Because of the zero lower bound on nominal interest rates, the Fed could not cut the funds rate as much as it wanted to during the recession and early in the recovery. Policy was too tight during this time, and keeping the funds rate at zero for an extended period helps the economy play catch up. Second, because long-term interest rates and other asset prices depend on expectations of future policy, committing to a lower-than-normal policy rate in the future can help stimulate the economy today.

Because of the longer period of zero rates, the optimal control policy achieves different outcomes for the economy. The unemployment rate falls faster than under a Taylor Rule approach, which is of course the whole point. But inflation also rebounds more quickly, and in fact overshoots the Fed's target for a period of time. This point is worth emphasizing: above target inflation is not considered a problem, but rather is an intentional byproduct of the strategy — much like the chess player who sacrifices an important piece to achieve some broader goal.

The major criticism against an optimal control approach to monetary policy is that the outcomes depend heavily on certain assumptions. We would highlight these three:

  1. Policymakers and the general public both know how the economy works
  2. The policy path is transparent and perceived as credible by the public
  3. Inflation expectations are firmly anchored

In our view these assumptions are very strong. Indeed, it is ironic that this approach has gained prominence in light of the backlash against mainstream macroeconomic models after the financial crisis.

Focusing on the assumptions behind optimal control can help us understand the risks inherent in the strategy. Take the second assumption for example: that the future path for monetary policy is transparent and considered credible.

Despite the Evans Rule framework in place at the Fed, markets began to doubt the credibility of the forward guidance when officials considered pulling back on QE this summer. The communication approach used by the Bank of England faced similar challenges. Part of the reason for this limited credibility is that investors know policymakers will have an incentive to renege on their promises in the future.

Fed officials cannot guarantee they will always stick with the optimal control game plan, and thus their forward guidance could remain under pressure during the exit process. The assumption about inflation expectations is also problematic. Overshooting the inflation target is not very costly if expectations remain stable, but could be very costly if they are not. This point was made in a 2008 paper by San Francisco Fed president John Williams (at the time a Fed staffer). He argued that optimal control "works extremely well when private expectations are perfectly aligned with those implied by rational expectations; however, if agents are learning, expectations can deviate from those implied by rational expectations, and the finely tuned optimal control policy can go awry. In particular, by implicitly assuming that inflation expectations are always well-anchored, the optimal control policy responds insufficiently strongly to movements in inflation, which results in highly persistent and large deviations of the inflation rate from its target."11

In her speeches Yellen points out that she uses a variety of tools and methods, including traditional Taylor Rules. However, she seems to prefer the optimal control approach at the moment, pointing out that Taylor Rules do not "adjust for the constraints that the zero lower bound has placed in conventional monetary policy" and do not "fully take account of the protracted nature of the forces that have been retraining aggregate demand" (June 6, 2012). Thus, although she offers some caveats, optimal control appears to figure prominently in Yellen's policy analysis.

Optimal control is a bold approach to monetary policy. If the assumptions hold, it could lead to meaningfully better outcomes for employment and inflation than traditional Taylor Rule-like approaches. However, it is also more accident prone — over the short run because the rate path is not fully credible, and over the long run because stable inflation expectations are not guaranteed. Look for the Yellen Fed to consider more communication changes in an effort to limit these risks and improve the credibility around the strategy. For bond market investors, Yellen's embrace for optimal control is probably helpful for the near term. But this will not necessarily always be the case, and optimal control could be a source of volatility down the road.

Bubbles, banks and bonds

Although Ben Bernanke took over as chair of the Federal Reserve before the global financial crisis, his views on asset price bubbles were still very much in focus. We now know that the U.S. housing bubble was cresting at the time. But even before that there had been a long debate in policy circles over asset price bubbles and monetary policy, focusing on whether the Greenspan Fed should have done more to stem the equity market euphoria in the 1990s.

Bernanke and other senior Fed officials at the time had a laissez-faire attitude toward bubbles. The Fed could clean up the mess after the fact but should not attempt to address imbalances directly. Bernanke saw two main problems with a more activist approach: bubbles were difficult to identify, and they are difficult to pop safely, at least using monetary policy tools. That latter, he said, would be like trying to "perform brain surgery with a sledgehammer."12 Ethan Harris, chief economist of Bank of America-Merrill Lynch, stressed a third reason for the Fed's stance on bubbles: plausible deniability.13 Bubble popping has negative short-run consequences and could therefore expose the Fed to public criticism, possibly threatening its independence. Staying out of the fray is a safer strategy in that regard.

Yellen supported this precrisis consensus. For instance, she said in 2009 that before the financial crisis central bankers "would have argued that policy should focus solely on inflation, employment and output goals — even in the midst of an apparent asset-price bubble. That was the view that prevailed during the tech stock bubble and I myself have supported this approach in the past."14 Although Yellen rightly expressed concern about the housing bubble before many economists, she stuck to the "do no harm" view when it came to monetary policy implications.

Addressing the housing bubble in 2005, she said, "For one thing, no one can predict exactly how much tightening would be needed, or by exactly how much the bubble should be reduced. Beyond that, a tighter policy to deflate a housing bubble could impose substantial costs on other sectors of the economy."15

Today central bankers are at least talking a lot more about bubbles and financial stability. As Chairman Bernanke said in his George Washington University lecture series last year: "In the decades before the crisis, central banks often viewed financial stability policy as the junior partner to monetary policy. The crisis underscored that maintaining financial stability is an equally critical responsibility."16 Similarly, Yellen has said that a "greater focus on financial stability is probably the largest shift in central bank objectives wrought by the crisis."17

Based on officials' public comments as well as published research from Fed staff economists, we see two high-level principles emerging. First, the Fed and other regulators are more focused on preventing vulnerabilities than predicting shocks. No one knows what could derail the economy or send asset prices lower in the future, but the impact of any shock would be amplified through a weak financial system. Fed officials are therefore paying most attention to measures of systemic vulnerability, including bank capitalization and liquidity, leverage across the financial system, underwriting standards and asset valuation. Second, policymakers appreciate the relationship between financial conditions and the build-up of risk-taking. Easy financial conditions can stimulate growth and help achieve full employment, but sanguine markets also incubate systemic risks. As put neatly by Fed staff economists: systemic risk tends to build when measured risk is low.18

Exhibit 7 illustrates the intuition behind this trade-off (which we adapted from Fed research). When large shocks hit the economy financial conditions tend to tighten. However, the degree of tightening depends on the vulnerability of the financial system — the capitalization of banks, the amount of leverage, etc. To prevent extreme disruptions in financial conditions, such as those that occurred 2008, policymakers should aim to keep financial system vulnerability relatively low. But therein lies the rub: to keep systemic risk low, financial conditions may need to be tighter in normal times — as shown on the left side of the chart. Avoiding future crises means paying higher costs today.

Exhibit 7: Fed faces trade-off between financial stability and growth:
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Minneapolis Fed President Narayana Kocherlakota highlighted this trade-off in a speech earlier this year (he uses the term "real interest rate" instead of financial conditions, but the meaning is the same):19

"The Committee will need to confront an ongoing probabilistic cost-benefit calculation. On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis — a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives." (His emphasis).

This renewed focus on financial stability can be thought of as adding a third "gap" to the Fed's other objectives. In the precrisis framework, the Fed set monetary policy based on the "inflation gap" — the difference between inflation and its target — and the "unemployment gap" — the difference between the unemployment rate and its natural level. Today the Fed may also need to pay attention to a "risk-taking gap" — the degree to which risk-taking across the financial system is consistent with low systemic vulnerabilities.

The challenge is that while Fed officials are confident about the relationship between the inflation gap and unemployment gap, they are less sure about the relationship between the unemployment gap and the risk-taking gap. Can the economy reach full employment before systemic risks get too high, or might financial stability concerns become important much sooner? This is the cost-benefit calculation President Kocherlakota and others have alluded to.

We are unsure about how much these ideas will affect policy in practice, though there are some encouraging signs. For example, concern about credit market overheating seems to have played a role in the debate around QE tapering this year. Some officials have also expressed openness to using monetary policy to achieve financial stability goals. Governor Jeremy Stein, for example, pointed out that monetary policy has the advantage that it "gets in all the cracks" — i.e. it affects all market participants, unlike regulatory changes that are more targeted.20 We have also seen other central banks, such as the Reserve Bank of New Zealand, use targeted measures to address the risk of bubbles.

At the same time, Fed leadership remains resistant to the idea that monetary policy should be used for financial stability purposes. The traditional view still holds: bubbles and financial stability are a matter for supervision and regulation — or what central bankers now call "macroprudential" policy. Yellen has stated that this is her own "strong preference."21

The macroprudential approach leaves many unanswered questions, in our view. Our biggest worry is more political than economic. Because of long-standing precedent, there is a public constituency behind the idea that the Fed has the right to adjust interest rates to manage the economy. We doubt such public or political support exists for macroprudential rulemaking, which would put the Fed in direct conflict with interest groups (e.g., regional commercial banks). For this reason we would not be surprised if interest rates became the standard bubble-popping tool in the future, even if theory says other approaches would be better.

This distinction matters greatly for fixed-income markets. In brief, a policy approach that leans more heavily on macroprudential tools is more favorable for interest rate markets, because these tools affect the state of the economy. But, unlike interest rate policy, they do not affect the yield curve directly. All else equal, macroprudential "tightening" is actually bullish for Treasuries because the actions weaken the growth outlook. Thus, whether Fed officials care about asset price bubbles is only one part of the equation. Bond investors also need to focus on which tools they are using — interest rates or macroprudential measures.

About Janet Louise Yellen

Personal: Born August 13, 1946 (age 67) in Brooklyn, NY. Married to George
Akerlof (winner of the Nobel Prize in Economics in 2001).

Education: Undergraduate degree from Brown University (1967) and Ph.D. from Yale University (1971).

Political affiliation: Democrat.

Academic career:
1971–1976: Assistant professor, Harvard University
1974: Research fellow, Massachusetts Institute of Technology
1978–1980: Lecturer, London School of Economics
1980–present: Professor, University of California Berkeley

Fed experience:
1977–1978: Staff economist at Federal Reserve Board
1994–1997: Governor of Federal Reserve Board
2004–2010: President of Federal Reserve Bank of San Francisco
2010–present: Vice Chair of Federal Reserve Board

Other policymaking experience:
1997–1999: Chair of White House Council of Economic Advisors
1997–1999: Chair of OECD Economic Policy Committee
Past advisor to Congressional Budget Office and various think tanks

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1. Macroeconomic Advisors blog post, March 12, 2010. Larry Meyer's book is A Term at the Fed: An Insider's View (Harper-Collins 2004).

2. Janet Yellen, "Challenges Confronting Monetary Policy." March 4, 2013.

3. "Interview with Janet Yellen." The Region, Federal Reserve Bank of Minneapolis, June 1995.

4. Christopher Erceg and Andrew Levin, "Labor Force Participation and Monetary Policy in the Wake of the Great Recession." Working Paper, Federal Reserve Bank of Boston, April 2013.

5. The Evans Rule, named for Chicago Fed President Charles Evans, proposes that, in general terms, Federal Reserve monetary policy ought to be tied to macroeconomic indicators. As it is being employed by the Bernanke-led Fed, the rule aims to reduce the unemployment rate toward a guidepost of 6.5% while keeping expected inflation below 2.5% by keeping the federal funds rate low.

6. Most economists believe — and Chairman Greenspan said at the time—that measured inflation in the CPI and other indices overstate the true rate of inflation in the economy. Thus, Greenspan's zero inflation target was meant to allow some positive inflation in the CPI to account for measurement bias.

7. Janet Yellen, "Policymaking on the Federal Open Market Committee (FOMC): Transparency and Continuity." May 31, 2005.

8. Janet Yellen, "2006: A Year of Transition at the Federal Reserve." January 19, 2006.

9. Aside from cases in which measured inflation was pushed temporarily higher by one-time factors.

10. This feature is not unique to optimal control. Other types of policy rules, such as nominal GDP targeting, currently call for similar short rate paths.

11. John Williams and Athanasios Orphanides, "Learning, Expectations Formation, and the Pitfalls of Optimal Control Monetary Policy," Federal Reserve Bank of San Francisco Working Paper, 2008.

12. Ben Bernanke, "Asset-Price ‘Bubbles' and Monetary Policy." October 15, 2002.

13. Ethan Harris. Ben Bernanke's Fed. Harvard Business Press, 2008.

14. Janet Yellen, "A Minsky Meltdown: Lessons for Central Bankers." April 16, 2009.

15. Janet Yellen, "Housing Bubbles and Monetary Policy." October 21, 2005.

16. Ben Bernanke, "The Federal Reserve and the Financial Crisis." March 29, 2012.

17. Janet Yellen, "Panel Discussion on ‘Monetary Policy: Many Targets, Many Instruments. Where Do We Stand?'" April 16, 2013.

18. Tobias Adrian, Daniel Covitz and Nellie Liang, "Financial Stability Monitoring." Federal Reserve Finance and Economics Discussion Series, 2013–21.

19. Narayana Kocherlakota, "Low Real Interest Rates." April 18, 2013.

20. Jeremy Stein, "Overheating in Credit Markets: Origins, Measurement and Policy Responses." February 7, 2013.

21. Janet Yellen, "Panel Discussion on ‘Monetary Policy: Many Targets, Many Instruments. Where Do We Stand?'" April 16, 2013.

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The views expressed are as of October 2013, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.

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