Janet L. Yellen has completed her term with unemployment much lower than it was when she began, with inflation low and closer to target, and with the financial system better capitalized and more liquid. What more can anyone ask from a Fed chair?
Yellen's success is a tribute to her judgment and thoughtfulness. Importantly, though, like Alan Greenspan in the 1990s, she recognized quickly a major structural change in the economy and adjusted policy away from where traditional models would guide it. In Greenspan's case, the structural change was the acceleration of productivity growth. In Yellen's, it was the decline in the neutral rate of interest — the interest rate at which saving and investment would balance without either a major acceleration or deceleration in growth.
The fashionable view at the Federal Reserve and elsewhere when Yellen took office in 2014 was that growth was slow despite very low interest rates because of "headwinds" — transitory factors associated with the financial crisis that would soon recede. Without the headwinds, it would be possible for the economy to enjoy sustained growth with the "normal" 4 percent federal funds rate. On this view, the near-zero rate policy in place was highly expansionary and risked dangerous inflation.
By 2014, after five years of financial repair, the headwinds theory was losing credibility. Estimates of the neutral rate were starting to come in suggesting that it had been trending down for a long time. More straightforwardly, despite near-zero rates and the completion of financial repair as measured by credit spreads in 2009, growth remained slow. That is why I sought to resurrect the secular stagnation theory — the idea that the economy, except at moments of financial excess, was likely to suffer from an excess of saving over investment and be prone to sluggishness and insufficient inflation.
Without endorsing the idea of secular stagnation, Yellen led the Fed gradually but firmly to the recognition that the neutral rate had declined significantly, and to the corollary conclusion that policy was not as expansionary as generally supposed. Her instincts were corroborated and even proved to have been, if anything, too cautious as growth and inflation generally fell short of the Fed's expectations during her tenure — even as interest rates were kept lower than expected and federal deficits increased more than expected.
It is fortunate for the U.S. economy that Yellen recognized changes in its structure and deviated from models and policy rules derived from historical experience. Had she followed such models, we quite likely would be in recession right now. Yet it must be acknowleged that growth in recent years associated with low interest rates would not have been as great as it was without the stock market increasing at a manifestly abnormal rate and without increases in borrowing that far outstripped growth in incomes.
Thus the first challenge facing the estimable Jerome H. Powell as Fed chairman is working out how to achieve growth that is both adequate and financially sustainable. Even with very low interest rates, the normal level of private saving consistently and substantially exceeds the normal level of private investment in the United States. And the differential is magnified by inflows of foreign capital. This creates a deflationary tendency that can be offset only by budget deficits or financial conditions that artificially depress saving and increase investment.
Asset values and levels of borrowing cannot indefinitely grow faster than gross domestic product, even though their ability to do so for a time has contributed to economic success over the past few years. If the Fed raises rates sufficiently to assure financial stability, there is the risk that the economy will slow too much. If it focuses on maintaining the growth necessary to meet its inflation target, there is the risk of further increases in leverage and asset prices setting the stage for trouble down the road.
There is a difficult balance to be struck. Except in the aftermath of recessions, it has been a long time since the U.S. economy grew well with a stable financial foundation. History will judge how stable the financial conditions of recent years have been. Prior to that, we were in recovery from the 2008-2009 recession. That in turn was preceded by a period of financial excess in housing and other markets. Prior to that came the 2001 recession and recovery, which in turn was preceded by the Internet and stock market bubbles of the late 1990s.
So it has been a generation since the U.S. economy enjoyed stable, financially sustainable growth from a position of strength. Good luck, Mr. Chairman.