Approaching a historic turn in U.S. monetary policy, Janet Yellen has staked her tenure as chair of the Federal Reserve on a simple principle: she'd rather fight inflation than another economic downturn.
Interviews with current and former Fed officials indicate that Yellen and core decision-makers at the U.S. central bank are determined not to raise interest rates too early and risk hurting the fragile U.S. economy.
It's a commitment that will be vigorously tested in coming months as pressure builds inside the Fed, among Republicans on Capitol Hill, and perhaps even in financial markets, for the Fed to acknowledge a strengthening U.S. economy with its first interest-rate increase in more than eight years. A global central bankers' conference in Jackson Hole, Wyoming next week will give Yellen a major stage on which to press her case.
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After taking over from Ben Bernanke in February, she has developed a distinct style: off-the-cuff and personable in public appearances, unusually direct in calling attention to the plight of the unemployed, meticulous in her preparation for Fed meetings and highly attuned to the opinions of her colleagues, the Fed sources say.
A common adjective used to describe her in meetings is "over-prepared." She is able to deeply question staff and colleagues about the fine points of their presentations, and so far has been able to forge consensus statements that have satisfied the Fed hawks most concerned about the inflation threat while keeping the central bank focused more on employment.
The nightmare scenario she wants to avoid is hiking rates only to see financial markets and the economy take such a hit that she has to backtrack. Until the Fed has gotten rates up from the current level near zero to more normal levels, it would have little room to respond if the economy threatened to head into another recession.
Inflation, on the other hand, is a familiar foe that Fed officials say they are confident they can control with conventional policy tools.
"If the Fed were to generate too much economic growth and higher inflation, that is a much better situation to be in than one of a faltering economic recovery and the need to rely even more on unconventional tools," said David Stockton, the Fed's chief economist until 2011 who is now a senior fellow at the Peterson Institute for International Economics.
"The Fed knows how to contain inflation if it is moving," he said, while the impact at this point of another downturn "are more uncertain and hard to counter."
The risks of moving too soon, Stockton and others in and outside the Fed say, include snuffing out an already tepid housing market recovery with higher mortgage rates, depressing business investment and durable goods purchases, and triggering sudden declines in asset prices.
And after extraordinary efforts to right the U.S. economy after the financial crisis struck, there would likely be little appetite among Republicans or other fiscal conservatives on Capitol Hill to use fiscal policy to counter a fresh recession, making it all the more important for Yellen to avoid helping to cause such a reversal.
"The challenge that she and the Fed as an institution face is to support the recovery, because fiscal policy ... is no longer on the table for both political and economic reasons," said David Lipton, first deputy managing director at the International Monetary Fund. "Now that (the economy) is recovering, the challenge is to gauge its strength and make sure it stays on the right path."
The other scary scenario is that a bout of swifter-than-expected inflation could erode three decades of hard-earned confidence that prices will remain under control, which in turn could make it easier for higher inflation to take firm root. The Fed's more hawkish officials also worry that the longer rates remain ultra low the more likely it is that troublesome financial bubbles will form.
Philadelphia Federal Reserve Bank President Charles Plosser formally dissented over the current dovish approach at the central bank's last policy meeting, while in recent weeks Richard Fisher of the Dallas Fed has amplified his concern that the bank is falling behind the inflation curve.
But even Fisher, one of the Fed's most outspoken hawks, credited Yellen's "extremely thoughtful" way of taking into account the views of other policymakers, a factor he said prompted him not to dissent.
"She may be new to the chair but she's well respected and she knows all the personalities in the room," said former Fed Governor Elizabeth Duke. Jeffrey Fuhrer, senior policy advisor at the Boston Fed, said Yellen's communications style is "a little more open and accessible" than her predecessor Bernanke. Adding: "She's a bit more approachable somehow."
The central bank is also watching the November mid-term elections with particular interest: a Republican takeover of the Senate could give momentum to a proposal that would force the Fed to rely on a mechanistic rule to set interest rates based on the levels of inflation and unemployment in the economy. That would undermine the collective judgment Yellen feels is needed to guide the economy in the aftermath of the financial crisis.
SIGNS OF PATIENCE
Despite a falling unemployment rate and inflation that is rising toward the Fed's 2-percent target, Yellen has in the last six months managed to shift investors' attention to stagnant wage growth and the high number of Americans who have given up the search for work.
She recently described higher inflation readings as "noisy," noting that overshooting the target is "at most a risk that we could face somewhere down the road."
At an IMF event in early July, she dropped another strong clue that she was not afraid to let the economy heat up, saying the threat of asset-price bubbles or other financial instabilities probably won't prompt an earlier-than-expected policy tightening.
That speech has been cited by a number of analysts who know Yellen as an important sign that she is putting her stamp on the evolving debate over how deeply central banks should be concerned with financial stability. Yellen was clear: raising rates would almost certainly cost jobs and growth, but wouldn't necessarily stave off bubbles.
In yet another sign of the Fed's patience, San Francisco Fed chief John Williams, often cited as a policy bellwether, recently made the theoretical case for allowing inflation to run temporarily above target to help bring down the number of long-term unemployed. Even broaching the idea of letting inflation run hot is a sensitive topic for a central bank that in the late 1970s and early 80s hiked its key rates to as high as 20 percent to slay sky-rocketing price increases.
Investors currently do not expect the Fed to lift rates until the second half of next year - a remarkable achievement for Yellen given the U.S. unemployment rate is near a six-year low and closing in on what Fed officials see as its equilibrium level.
Colleagues said that Yellen has adapted easily to her new role, yet what Stockton called her "stress test" lies ahead, and may begin this fall when the debate over interest rates intensifies.
The Fed expects to end one of its key crisis programs in October when it stops buying Treasury bonds andmortgage backed securities. Once that happens, the next step is to raise rates.
"You're going to see a battle ... that is wide open" among policymakers, predicted former Fed Vice Chair Alan Blinder.
"There are a zillion ways it could go wrong but the simplest way is that the Fed exits too slowly, in which case some of the fears of the inflation hawks will come true," added Blinder, now a Princeton professor. "The other is that the Fed moves too quickly — this is the one that often gets forgotten — and the recovery stalls or, even worse, gets reversed."
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