Bernanke Stole Yellen's Thunder, Condemns Fed to Weak Leadership

I had been one of those analysts that did not expect the Fed to announce tapering this month. There were two arguments that we had found compelling.  The first was inflation, as measured by the Fed's preferred metric, the core PCE deflator, was low and falling. The second was that the shift toward forward guidance would be more compelling if it was delivered by the person who would actually be there to implement it. 

I was wrong.  The Fed announced that tapering would begin next month.  The immediate market reaction was the best officials could have hoped for.  US interest rates were largely steady and the stock market rallied.   

A couple days after the tapering was announced, the US reported a sharp upward revision of Q3 GDP to 4.1%, the strongest in several years.  Although inventories rose sharply, the 2.5% increase in final sales was notably strong.  Household consumption appears to have accelerated in Q4.

Yet, I remain concerned about the longer-term cost of the Fed's action.  In particular, it undercuts the ability of Janet Yellen to provide strong Fed leadership at a particularly important moment for the country and for the Federal Reserve itself.  

The $10 bln of tapering that was announced starting in Jan, bring the Fed's continued balance sheet expansion to $75 bln a month is not material from a economic or financial point of view.  Indeed, arguably, with a reduction of Treasury supply due to stronger tax revenues and spending cuts, the portion of Treasuries the Fed buys (in the secondary market) may actually be a bit larger the previously.  

The Fed could have waited six weeks, by which time, Yellen would be the new chair and maybe another governor (or two) would have been nominated by President Obama.  The advantage of the Yellen Fed announcing the tapering is that it would have 1) undermined arguments that she is a super-dove, 2) shown her as a independent and strong leader, and 3) would have boosted the credibility of the forward guidance.  

Now Yellen will be perceived to be following the course that has been more or less outlined by the Bernanke Fed.   Bernanke effectively slashed the Yellen's degrees of freedom that are necessary for strong leadership, and without securing much benefit.  If the Fed had not tapered, the statement could have lowered the bar to tapering in early 2014. 

Yellen's ability to lead may also be undermined if President Obama nominates, as press reports suggest is likely, Stanley Fischer, as vice-chairman of the Board of Governors.  Stanley Fischer, until recently the head of the central bank of Israel, is a bit of a rock star among economists.  He was the Ph.D thesis adviser for Bernanke and Draghi (and Mankiw).  Fischer has also co-authored economic papers with Dornbusch and Blanchard, among others.  

And what of the forward guidance that the FOMC strengthened?  Forward guidance is quickly becoming the new deus ex machina.   Yet insofar as it denotes an attempt to help shape market expectations for the trajectory of monetary policy, it may be as old as central banking itself. Since it is well shy of a commitment, the key is how to make it credible.   Surely, the credibility would be enhanced if the people who made it also implemented it.   By delivering it prematurely, it was yet another way in which the FOMC's action denies Yellen's ability to put her stamp on the Fed, which is what strong leaders do.   

If this analysis is correct, the implications will not be immediately evident.  The corrosive effect of weak leadership is cumulative and especially evident when it is needed the most.  The transition in the year ahead, both in terms of policy and personal shifts (most have focused on the rotation of regional presidents in a somewhat more hawkish direction, though the changes on the Board of Governors may be more significant), will present their own challenges.   It is a shame that Bernanke denied her the mantle of leadership she deserves.