Janet Yellen Worries the Fed May Not Have the Tools to Fight the Next Downturn

The U.S. economy is booming. The country is close to full employment, with companies reporting healthy profits and the stock market more than tripling since its nadir in early 2009. While short-term forecasts continue to look good, a recession is inevitable. Eventually, everything that has gone up, up, up will begin to lose altitude. Then the country will look to the Federal Reserve to cushion the fall, or in an extreme case, prevent a full-on crash.

Janet Yellen saw all parts of the business cycle in her 14 years at the Fed. She warned of the housing bubble as president and CEO of the San Francisco Reserve Bank, but later admitted she misjudged how much damage it could do to the economy when it finally popped. As the crisis ebbed, leaving an economy in the deepest recession in generations, Yellen moved to Washington to become the Fed’s vice chair and in 2014, its chair. In these roles, she experienced firsthand how a central bank navigates a financial crisis and its aftermath.

“This was all-hands-on-deck monetary policy—to do everything possible to get people back to work, to create jobs,” she said.

In a conversation with Yale Insights, Yellen discussed her time as Federal Reserve chair and how it influenced her thinking about what “all hands on deck” should mean next time.

Q: How do you feel about the dual mandate at the Fed? How hard was it to balance the two sides when you were chair?

Congress directed the Fed to pursue price stability and maximum employment as goals. Both are very important. It makes a great difference to people if we’re in a full-employment economy where there are ample jobs for people who want to find work. Price stability is also an important goal that’s in the mandate of every central bank that I know about. Low and stable inflation helps people do financial planning. It avoids arbitrary redistributions of wealth. For the dollar, which is a global key currency, it enables it to serve as a stable source of value.

It’s possible for them to be in conflict, and during the ’70s and ’80s, very often they were. Starting in the late ’60s, inflation rose to levels that were widely viewed as too high. Trying to bring inflation down from unacceptably high levels means running a tight monetary policy that can impair employment. I suppose the most famous episode of a tradeoff was when Paul Volcker became chairman and started really raising interest rates dramatically in 1979 and ’80. A huge recession ensued in 1981 and ’82.

More recently, we had a very serious global financial crisis leading to a tremendous recession. Unemployment rose up to 10%, while inflation fell below the Fed’s 2% goal. Frankly, this was not a tradeoff situation. This was all-hands-on-deck monetary policy—to do everything possible to get people back to work, to create jobs. The threat was that inflation would remain below 2% or we could even face deflation, which is a very serious situation. We really didn’t face any tradeoff at all. It was a question of, What can we do?

Now, perhaps a tradeoff is developing again with the 3.7% unemployment rate and inflation sitting at 2%. There is danger that the economy will overheat and inflation will start rising. The unemployment rate is probably below levels that are sustainable in the long run. This is the first time in all those years since the crisis that we might be getting back to a situation where the Fed might face a tradeoff.

Q: How ready do you think the Fed is for the next financial crisis?

I think it is a real concern that the Fed might not have all the tools that are needed in order to respond. The fundamental reason why it’s a problem is that even before the financial crisis, the general level of interest rates in most developed economies, including the United States, had been drifting down.

If the short rate got back to 3%, which is now considered a normal nominal level, and a serious downturn hit, the scope to cut short rates to address it before hitting the so-called zero lower bound is only 300 basis points. That just isn’t what we have had or used historically to address downturns. That’s the fundamental problem. The Fed is, I think, thinking hard and about to undertake a public review of strategies and tools to think about how they can address the problem, if at all. It’s not a simple question. I think there may be some things that they can do.

There were tools that were used in the aftermath of the crisis, particularly asset purchases. The Fed purchased large quantities of long-term treasury bonds and mortgage-backed securities, those backed by Fanny and Freddie, with the objective of pulling down longer-term interest rates. The Fed also used forward guidance—statements to influence the market’s perception about the likely path of short rates. Both tools were effective and I think they should remain in the arsenal.

Q: What type of recession would it take to hit that zero mark?

It wouldn’t take a very serious recession at all. In a typical postwar downturn, the Fed has found it necessary to cut interest rates by five percentage points.

In my own view, the Fed should use forward guidance for such a situation far more aggressively and more quickly than we did after the crisis. We were experimenting and I think we learned a lot about how to give forward guidance. My own view is that the Fed’s objective should be to bring long-term rates down very substantially as soon as they hit the zero lower bound. The way to do that is to assure markets that short-term rates will stay low for a very long time—longer than would’ve been expected with a typical monetary policy response.

The Fed also needs to worry that in a downturn, inflation expectations don’t fall over time. When short rates hit the zero lower bound, inflation may remain for a prolonged time under 2%. I frankly think it’s appropriate after a long period when inflations run shy of 2% to then allow inflation to run above 2%. I would be inclined to establish as a target something like 2% on average over the business cycle. In the aftermath of a significant negative shock to the economy, when policy’s constrained by the zero lower bound, holding rates very low for a long time tends to create a situation in which inflation will overshoot 2%, at least for a while on a temporary basis.

This approach is sometimes called price-level targeting, as opposed to inflation targeting. I’m not in favor of adopting a formal price-level target, but an approach along the lines of seeking “2% on average over the business cycle” could help. Other countries have used different approaches. Japan has used something called yield-curve control. They seek to actually target, through direct interventions, the level of the 10-year government rate. That’s something that could be considered although I have qualms about doing that in the United States. Some countries have taken short rates into negative territory. Again, I’m not sure that would be an effective approach, especially in the United States, but it’s something that could be considered.

Q: What actions, if any, can the Fed take to address long-term challenges such as income inequality?

The tool that the Fed has is monetary policy and it affects the level of demand in the economy, which, in turn, affects the state of the labor market and the overall unemployment rate—in other words, the quantity of jobs in the economy. Is that a tool to address problems of inequality? Well, yes and no.

A very high-unemployment economy, like we had in the financial crisis, takes a particularly heavy toll on those who are least advantaged. I can give you an example: the African-American unemployment rate is always higher than the rate for other groups. It was around 7% before the financial crisis in 2007. At its peak after the financial crisis, it rose to over 16%. Now, as the economy has strengthened, the African-American unemployment rate has fallen to just over 6%, the lowest level in the history of that series since 1951.

A downturn in the economy is something that increases inequality. It hits the least advantaged hardest. Then when the economy recovers, those groups see disproportionate gains.

But inequality also has structural causes. For the last 30 or 40 years, really at least since the mid ’80s, a good half of the workforce has seen essentially no gains in their real income. Two structural reasons for this are technological change and globalization, which have diminished job opportunities and pushed down the wages of less-skilled Americans in the workforce. This is the type of phenomenon that the Fed can’t address.

The Fed can play a convening role in working with community-development organizations and banking organizations: provide research and understanding, bringing those groups together to try to help the banking organizations fill the needs of low income communities—something mandated by the Community Reinvestment Act. That is a direct role the Fed plays that’s helpful, but it isn’t nearly enough to counter deep structural factors raising income inequality.

Q: There were a lot of predictions that quantitative easing would lead to a spike in inflation. Why were they wrong?

The people who thought that quantitative easing—purchasing longer-term securities and paying for them by creating reserves—would spur inflation simply didn’t have a good undergraduate economics class. The situation that the country was in after the financial crisis, in economics textbooks when I studied here at Yale, we used to call it a liquidity trap. After the financial crisis, the economy’s ability to supply goods and services was way, way in excess of the demand for them. The Fed was trying to do everything it could to generate demand and it lowered interest rates to zero. Still, demand was insufficient. Quantitative easing was just an attempt to lower long-term interest rates after short rates were already at zero to generate demand for the economy’s goods and services. You would not expect to see inflation move up until demand got to the point where it was pressing against the economy’s resources.

Also, the reserves that the Fed created in buying those assets are different now than they used to be because the Fed is paying interest on those reserves. Before 2008, reserves paid no interest. So reserves are unlike money, which we usually think of as an asset that pays no interest; to make sure that those reserves don’t create undue inflation, the Fed is raising the interest it pays on those reserves, which is appropriate to control inflation.

Q: Did your approach to monetary policy change during your time at the Fed?

The defining experience of mine during my years at the Fed was the financial crisis. The Fed was blamed—wrongly, I think—for the interventions it made in the aftermath of the crisis. It was viewed as supporting Wall Street. That was a misperception, because the Fed’s focus throughout was squarely on Main Street, on trying to make sure that there was a continued flow of credit to households and businesses. It was bad enough that the unemployment rate rose to 10%. If the Fed hadn’t intervened in all the creative ways that it did, with liquidity programs and massive interventions, the unemployment rate could’ve been very much higher than that. We could’ve had another Great Depression.

What changed for me was the understanding that the Fed needed not just to use the tools it was given to come in and pick up the pieces after a financial crisis, but to develop the capacity to detect emerging threats to financial stability. We’ve been very focused on that as a top priority ever since the financial crisis; we’ve added a division of financial stability to monitor threats, to understand ways in which they can develop not only in the banking system, but outside of it, in the so-called shadow banking system.