It looks highly likely that President Obama will nominate Janet Yellen to be the next chairman of the Federal Reserve. But he won't be done reshaping the central bank after that. Obama will also need to appoint someone to replace Yellen as vice-chair, and has at least two more empty or soon-to-be-empty slots on the seven-member board of governors. (Here's a full rundown of the vacancy situation from Ylan Mui).
There's one name that several Fed watchers, who I have spoken to since Yellen became the clear favorite for chairman, have independently mentioned as a logical contender to be Yellen's No. 2: Jeremy Stein, a Harvard economist who was appointed to the board of governors in 2012 by Obama. A speech he gave Thursday in Germany shows why, but more on that in a bit.
In 16 months at the Fed, Stein has established himself as a thoughtful examiner of the interplay between the Fed's monetary policies and financial markets. He also is known for particularly thinking hard about the how, when, and whether low interest rates and quantitative easing can prompt new bubbles. At the same time, he has been a reliable vote for Ben Bernanke's easy money policies. In other words, he is worried about the risks that the Fed is creating, but so far believes its ability to help the economy supersede those risks.
If he were named vice-chair, that would make him a bit of a hawkish counterweight to Yellen, who has been the leader of the Fed's dovish wing, pushing Bernanke and other colleagues to do whatever it takes to reduce unemployment. The president has said in several settings that he wants the Fed to do its part to try to end the bubble-and-bust cycle that the economy has been stuck in for the last couple of decades, and Stein has done as much thinking about those issues as anyone.
Stein and Yellen would bring different, but complementary, intellectual approaches to Fed leadership as well. She is a leading scholar of employment, and he is a leading scholar of financial markets. That is just the kind of combined knowledge you would want to see at the top ranks of the nation's central bank at a time that unemployment remains very high and the Fed's massive balance sheet is creating waves of volatility in global financial markets.
The best argument against a Stein appointment is that he and Yellen are too far apart on policy and approach, and that this would lead to discord and ineffective leadership of the central bank. Another wrinkle is that Stein will hit the two-year mark of his service at the Fed in May, and Harvard has in the past been strict about allowing faculty only two years of leave for government service. If the president wanted to appoint him for a four-year term as vice-chair, it may well force Stein to choose between that and giving up a lifetime guaranteed job at the world's leading university.
Stein's speech Thursday in Frankfurt, at the Center for Financial Studies, shows how his mind works on some of the crucial issues facing the central bank.
Stein's thesis is that the Fed's zero-interest rate policies have had effects through some less widely understood channels. Certain investors -- banks, insurers, pension funds -- really need investments that spin off lots of cash. When interest rates are low, that means they must "reach for yield," buying riskier assets than they would really prefer just to receive yields that match their targets.
As a result, he finds, when the Fed buys up longer-term bonds in its quantitative easing programs, it drives all sorts of interest rates down, in part because lower rates drive other investors to take on even more risk by buying up corporate debt or emerging market bonds or whatever. They have to look elsewhere to get the yield they need. Here it is in Stein's words:
According to this view, real and nominal term premiums were low not just because we were buying long-term bonds, but because our policies induced an outward shift in the demand curve of other investors, which led them to do more buying on our behalf--because we both gave them an incentive to reach for yield, and at the same time provided a set of implicit assurances that tamped down volatility and made it feel safer to lever aggressively in pursuit of that extra yield. In the spirit of my earlier comments, let's call this the "Fed recruitment" view.
And this may have even helped the Fed's easy money policies be more effective, he notes. "To be clear, I don't mean this as a criticism of the set of policies that we have in place," Stein added. "Quite to the contrary--it can be useful to enlist help when you have a big job to do." Without this channel, "I suspect that our policies would have considerably less potency and, therefore, less ability to provide needed support to the real economy. "
But the fact that Fed policy may be having big impacts through such a poorly understand channel suggests a certain wariness, he adds, and is likely a reason that seemingly small changes to Fed policy are creating so much volatility in financial markets.
He goes a step further, saying that he would have been content to begin tapering the Fed's $85 billion-a-month bond purchases at last week's meeting (the committee, in a surprise decision, elected not to, though Stein did not formally dissent). And he acknowledged that the Fed's communication around its plans has been less than ideal.
I would have been comfortable with the FOMC's beginning to taper its asset purchases at the September meeting. But whether we start in September or a bit later is not in itself the key issue . . . What is much more important is doing everything we can to ensure that this difficult transition is implemented in as transparent and predictable a manner as possible. On this front, I think it is safe to say that there may be room for improvement.
And to that end, Stein even proposed a novel, even radical, way of making the exit from the Fed's QE policies more mechanical and less subject to misinterpretation, for example, explicitly tying the amount of bond purchases to changes in the unemployment rate.
Overall, Stein's Frankfurt speech was as persuasive an explanation I have heard of why, for example, Bernanke's discussion of a planned "tapering" of bond purchases at the June policy meeting sparked extraordinary moves in assets as varied as Indonesian government bonds and the South African currency.
And whether Stein finds himself in the vice-chairman's job or back at Harvard next spring, it is the kind of thinking the president should be looking at as he chooses a team to accompany Yellen at the helm of the Fed.