Janet Yellen: Time to Tighten?

Abstract

In August 2015, Janet Yellen, chair of the Board of Governors of the Federal Reserve System (the Fed), was feeling uncertain. Many were trying to anticipate her decision about whether she and the Federal Open Market Committee (FOMC) would raise interest rates at the upcoming September meeting. But Yellen herself wasn't sure. Yellen wanted to understand the perspective of those who continued to worry about the consequences of expansionary monetary policy. To do so, and to understand the policy tradeoffs she faced, she had to consider the history of events that led to her current conundrum. Excerpt UVA-GEM-0139 Rev. Aug. 23, 2017 Janet Yellen: Time to Tighten? In August of 2015, Janet Yellen was, in a word, uncertain. Many were trying to anticipate her decision about whether she and the Federal Open Market Committee (FOMC) of the Federal Reserve System (the Fed) would raise interest rates at the upcoming September meeting. But Yellen herself wasn't sure. She was known for expressing concerns about unemployment—she had at times favored expansionary monetary policy to fight unemployment. But considering that interest rates had been at the lowest level in the Fed's history for over six years (Exhibit1), the unprecedented expansion of the monetary base since the Great Recession (Exhibit2), and the potential risks for asset price bubbles and eventual inflation, Yellen yearned for a normalization of U.S. monetary policy. The Fed's charter dictates a dual mandate: it must adjust monetary policy to achieve maximum employment and stable inflation. The challenge for Yellen—and for central banks around the world—was that these competing objectives were often difficult to balance. Furthermore, some members of the FOMC and prominent economists worried that efforts to achieve these objectives today could have adverse consequences for inflation and employment in the future. James Bullard, president of the Federal Reserve Bank of St. Louis, expressed his concerns in a February 2012 speech: The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. . . .