The Fed’s Surprise and Yellen’s Challenge

To ask what Janet L. Yellen, the nominee to succeed Ben Bernanke as Chair of the Federal Reserve, has in store for US monetary policy is to pose the wrong question. The real issue is the decline of the Fed’s policy effectiveness.

NEWPORT BEACH – The US Federal Reserve sparked a global – and now month-long – guessing game with its decision on September 18 not to “taper” its monthly purchases of long-term securities. The Fed does not surprise markets often, and this has been especially true of the Ben Bernanke-led Fed, which has devoted enormous time and effort to better communication, greater transparency, and timely management of expectations. Now that President Barack Obama has nominated Fed Vice Chair Janet L. Yellen to succeed Bernanke in January, there is even greater interest in what lies ahead for the world’s most important central bank.

To be sure, Fed officials did not do a great job of managing expectations in the weeks preceding their September policy meeting. Having also struggled to reclaim the narrative thereafter, there is great interest in understanding what led the Fed to act in such an uncharacteristic manner. Nonetheless, the real issue is that the Fed’s last-minute change of heart does not significantly alter the main challenge that the highly qualified Yellen will face: persistently weak economic fundamentals and doubts about the continued effectiveness of the Fed’s policy tools.

Five main arguments for the Fed’s decision to postpone the taper have frequently been proposed. One view is that the Fed recognized that its specification of policy thresholds (based on the unemployment rate) understated the vulnerability of the US labor market. Another is that officials worried about excessive financial tightening after Bernanke’s mention in May of a possible taper, jeopardizing the economy’s gradual recovery.

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