Ross Levine
Senior Fellow; Willis H. Booth Chair in Banking and Finance, University of California, Berkeley
Dr. Ross Levine is the Willis H. Booth Chair in Banking and Finance at the University of California, Berkeley. For the past seven years, he has been the James and Merryl Tisch Professor of Economics at Brown University and director of the William R. Rhodes Center for International Economics and Finance.
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Janet YellenaEUR(TM)s challenges
By: Ross Levine
November 26, 2013

ItaEUR(TM)s a virtual certainty that Janet Yellen will soon become chairwoman of the Federal Reserve SystemaEUR"the agency that shapes interest rates throughout the economy and regulates and supervises major financial institutions. Yellen, the current vice chair, will face two monumental challenges, which both triggered active debate during her Senate confirmation hearings. How will she address them, and how will her decisions affect each of us?

The first involves monetary policy. The Fed has kept interest rates at unprecedentedly low levels, for an unprecedentedly long period, by buying an unprecedentedly large quantity of Treasury and mortgage-backed securities. These purchases, part of the famous quantitative easing program, raise the price of the securities and reduce their interest rates. The central bank has increased its holdings from about $970 billion before the financial crisis fully emerged in 2008 to about $3.8 trillion today, and the purchasing continues at a rate of $1 trillion per annum.

By keeping interest rates low, the Fed seeks to spur businesses to borrow more as a step toward expanding production and hiring more workers. But this strategy has its critics. During the hearings, some senators called it irresponsible because it has had, and is likely to have, only a minor effect on employment, yet it elevates the risk of future inflation. While the Fed has purchased trillions of dollarsaEUR(TM) worth of securities from banks, many point out, the banks have lent relatively little of their excess cash to businesses.

This raises the question: If banks are not lending much, even though they have an enormous stock of unused funds, can the Fed stimulate the economy more than it has by adding even more to this stock of funds by purchasing still more securities? In terms of the risks, the continuation of easy monetary policy raises the possibility of inflation, which could severely hinder growth in the coming years. Critics are skeptical that the Fed could reverse its policies in time to avoid triggering an inflationary spiral.

Other critics note that low rates have had detrimental distributional effects. They are great for borrowers, such as the government and corporations, but unfortunate for savers who seek a steady stream of interest income. For instance, older people who have prudently accumulated retirement nest eggs cannot generate substantial interest income by buying safe bonds.

The McKinsey Global Institute recently tackled the issue with the study aEURoeQE and Ultra-Low Interest Rates: Distributional Effects and Risks.aEUR? It demonstrated that since the crisis, the federal government has benefited to the tune of $900 billion and banks and other firms have seen their profits boosted by $460 billion due to the low rate policy. In contrast, households, insurance companies and pension funds have sacrificed about $630 billion in revenue.

On her visit to the Capitol building, Yellen stood her ground. Under her leadership, she said, the central bank will attempt to achieve its mandated goal of full employment through stimulative monetary policy. She also assured officials that it would carefully monitor economic conditions and the amount of money in circulation and taper, or even reverse, QE to fulfill its second mandate: stable prices.

The second big challenge came from Sen. Elizabeth Warren, a Massachusetts Democrat who has been a relatively lonely but prescient voice on the need to improve the supervision and regulation of banks and markets. At YellenaEUR(TM)s hearings, Warren noted that aEURoeif the regulators had done their jobs and reined in the banks, we wouldnaEUR(TM)t need to be talking aboutaEUR? stimulus. In effect, she suggested that regulatory and supervisory issues should receive as much attention from the Fed as monetary policy.

While agreeing that regulatory issues are indeed as important as monetary policy, Yellen conceded little in regard to the FedaEUR(TM)s role leading up to the crisis. aEURoe[W]eaEUR(TM)ve massively revamped our supervision, particularly of the largest institutions,aEUR? she argued.

I hope the Fed chief-in-waiting listens to the senator. In the long run, sound supervision and regulation are crucial for creating a system that funnels creditaEUR"and hence opportunityaEUR"to those with the best entrepreneurial ideas. As the nationaEUR(TM)s major financial regulator, the central bank has a special obligation to communicate its views and intentions to the public and public officials. While the Fed has laudably improved the transparency of its monetary policy, openness has not been an attribute of its work overseeing the institutions that allocate capital in society.