When Ben Bernanke became Fed Chairman in 2006, his collection of speeches and academic papers turned out to be extremely relevant to the decisions he would take in office, especially after 2008. The same is likely to be true of his nominated successor who, pending her confirmation by the Senate, has now become the de facto voice of the Fed.

Google Scholar lists dozens of entries under the name Janet L. Yellen. These citations outline an extremely well considered economic philosophy that has developed along a consistent path since the early 1980s. A 67-year old leopard is unlikely to change its spots.

Recent Speeches

Ms Yellen is, of course, routinely described as one of the most dovish members of the FOMC and her speeches since moving to Washington as Vice Chair in 2010 have usually been one notch to the dovish side of Mr Bernanke himself. Recent speeches have established that she believes that interest rates should be held at zero for a longer period than would be implied by a normal Taylor Rule, even if inflation rises above 2 per cent for a while.

A devoted advocate of transparent communications, she firmly believes that the Fed should give explicit forward guidance about holding rates “lower for longer”, guidance which may need to be strengthened as the FOMC begins to taper its asset purchases. This could be her first task if tapering starts after she takes office in February.

On the precise date of tapering, Ms Yellen has offered five labour market tests which are usefully summarised in this brief paper by my colleague Juan Antolin-Diaz. Several of her indicators have improved somewhat since QE3 was launched, but not by enough to make early tapering an obvious decision. Furthermore, in her most recent major speech on monetary policy (on 4 March, 2013), she made it clear that she currently places more importance on maximising employment than on the inflation part of the Fed’s mandate:

With employment so far from its maximum level and with inflation running below the Committee’s 2 percent objective, I believe it’s appropriate for progress in the labor market to take center stage in the conduct of monetary policy.

Her friends say that she is only a dove because the current situation demands dovishness, and that she could be a hawk if she needed to be. For the most part, Ms Yellen has voted with the consensus in her many years on the FOMC (1994-97 and 2004 onwards). However, her supporters recall that she combined with Governor Larry Meyer to urge an increase in interest rates (unsuccessfully) on the Greenspan Fed in 1996. Way back then, she was an early American convert to 2-3 per cent inflation objectives as part of the Fed’s dual mandate.

Academic Research

Her concern about the wastage associated with high unemployment has been the most enduring themes of her academic research (well summarised here by Dylan Matthews). Although her writing has covered many diverse fields (such as a youthful paper on the adverse consequences of advertising in 1977, and another on the reasons for the rise in the number of children born out of wedlock in 1996), there have been two major themes which are of particular importance to her new role.

The first theme is to provide satisfactory micro-foundations for Keynesian economics.

There is no doubt that Ms Yellen has always been a Keynesian [1], which may antagonise many observers in the US, including some on the Senate Banking Committe which will need to confirm her.

She is a new Keynesian, not a post Keynesian [2], and like many similar economists in the 1980s, she became very concerned that her macro-economic beliefs did not have sound micro-economic underpinnings. At the time, Keynesian economics was under serious assault from Robert Lucas and others, who argued that in a world with flexible prices and wages, and with rational expectations about inflation, the economy would rapidly return to equilibrium after shocks, without any help from fiscal or monetary policy.

Ms Yellen and her Nobel laureate husband George Akerlof, both professors at UC Berkeley, helped to construct answers to this attack. They developed “efficiency” or “fair wage” models [3], which explained why profit maximising firms (in imperfectly competitive markets) would choose to set wages higher than the marginal product of labour, and would not rapidly adjust these wages downwards in a recession. They also explained the stickiness of prices by pointing to the “menu costs” associated with making changes in selling prices.

These deviations from flexible wages and prices became major planks in “New Keynesian” economics, in which the economy would return to equilibrium only slowly after shocks, leaving room for monetary policy to play a role in smoothing output fluctuations. The enduring importance of this work is that Ms Yellen is probably no longer plagued by doubts that her entire intellectual ediface may be built on shaky foundations. Although other economic schools remain unpersuaded, she is a conviction New Keynesian.

The second highly relevant theme of her work concerns the formation of expectations, and its links with the macro-economics of deep and prolonged recessions. Ms Yellen has always preferred to incorporate near-rational expectations into her models, but her definition of “rational” is a fairly wide one, encompassing modes of behaviour which human beings can be shown to adopt in practice, rather than those which are assumed to exist in economic theory [4].

The most important example of this comes from a Yellen paper in 2004, in which she contends that in practice people form their expectations for inflation very differently from the way in which economists generally assume [5].

Well before the start of the recent Great Recession, Ms Yellen argued that inflation expectations, and inflation itself, would get stuck at low levels in a deep recession, rather than falling into negative territory, as some models would imply. The consequence is that high and prolonged levels of unemployment will leave inflation moving sideways, implying that monetary policy can reverse the process, boosting output without raising inflation.

Conclusion

The implication of this is important. If the Fed nominee is a dove, which she is, it is because she thinks that a rise in inflation is improbable, not because she thinks it would not matter. Like many Keynesians of her generation, the rise in inflation in the 1970s was a scarring experience for her. Her 2004 paper summarises her approach rather well:

Stabilisation policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilization of labor and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level.

The fact that Ms Yellen is a dove today does not imply that she would tolerate rising inflation tomorrow. She will need to persuade the markets, and the public, of that in the coming weeks.

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Footnotes

[1] In 1988, she and her co-authors wrote: “The new Keynesian economics is particularly welcome because it makes common sense and, unlike the new classical theory, it fits the most important stylized facts of the business cycle: that cyclical unemployment is largely involuntary and that anticipated demand shocks do affect real output.”

[2] John Cassidy sums up her position in The New Yorker as follows: “Yellen is no radical. In many ways, she strikes me as a traditional American Keynesian—a modern representative of the breed that stretches back through Joseph Stiglitz and Paul Krugman (in his later incarnation) to James Tobin, Robert Solow, and Walter Heller, and, from the founding generation, to Paul Samuelson and Alvin Hansen. Contrary to what some of its conservative critics claim, American Keynesianism isn’t a left-wing creed: like John Maynard Keynes himself, it seeks to preserve the system rather than overthrow it.”

[3] Yellen again: “In simple English, if people do not get what they think they deserve, they get angry. It is this simple proposition that underlies our model….[In some instances] our model predicts that aggregate demand shocks will produce cyclical variations in unemployment, thus yielding demand-generated business cycles.”

[4] Yellen: “Near rational behavior is behavior that is perhaps sub optimal but that nevertheless imposes very small individual losses on its practitioners relative to the consequences of their first-best policy…Very small transaction costs of decision making or changing prices could account for large fluctuations in real economic activity.”

[5] Yellen: “Not everyone involved in price and wage setting may always think like an economist…Under some conditions, people may suffer from money illusion. Some employees may consider nominal wage cuts insulting or unfair, so that money wages may be sticky downwards. If so, the degree of downward real wage rigidity rises as inflation declines and the sacrifice ratio rises.”

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