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Pimco on the Federal Reserve: New Maestro, Seasoned Band


The process by which the US Fed carries out its duties is institutionalized, firmly rooted, and unlikely to change under Janet Yellen.

Editor's note: This story by Tony Crescenzi originally appeared on Pimco.

My first memory of witnessing the Federal Reserve's power to move markets is of a Thursday afternoon in the spring of 1983. I was at my first Wall Street job in an office full of stock brokers in downtown New York, just a few hundred feet from the New York Stock Exchange. It was at the end of the day, and a crowd of anxious brokers were standing beneath the ticker tape at the front of the room, watching the news feed, with pen and paper in hand. I had no idea why.

Then -- at precisely 4:30 p.m. -- there was a burst of noise. Curious, I asked a broker. He said that the Fed had just released its weekly money supply data. Huh? He described how Wall Street waited every Thursday with bated breath for the data because the Fed set interest rates by adjusting the money stock. In technical terms, the Federal Reserve operated under a reserve-targeting regime, adjusting the quantity of money to determine its price -- the interest rate level. The more money there was, the lower its price went. When money was scarce, interest rates rose.

No wonder Thursdays at 4:30 were a veritable sporting event.

Today, the Fed operates differently, targeting a specific interest rate and adjusting the quantity of reserves accordingly. In reality, this isn't completely true because the Fed, through its bond buying, has injected trillions of dollars into the financial system without any intention of having the money affect its policy rate because it can't -- the rate is at zero. Instead, the injections determine the effective policy rate, which is at some unknown level below zero, and they are meant to suppress interest rates and interest rate volatility, thereby compelling investors to move outward along the risk spectrum. This means that the new 4:30 is the Fed's bond buying, in particular its pace of tapering, because of how it will affect views about the timing of future rate hikes.

There's a bigger point in all of this, which is to highlight the ever-changing nature of the Fed's influence on markets evolving from its 100-year history. Still, one thing is constant: its ability to move markets. How it does this changes, but its basic goals and objectives don't change much. A key point of this article is to highlight how the process by which the Fed carries out its duties has been institutionalized, is firmly rooted and is unlikely to change, no matter who is at the helm.

Change at the Top: Enter Janet Yellen

Ever since President Woodrow Wilson signed the Federal Reserve Act at 6:02 p.m. on 23 December 1913, the Federal Reserve has been evolving into one of the most powerful institutions in the U.S and the world. The Act itself has been refined and other laws have been passed to shape the Fed into what it is today.

Fourteen individuals, beginning with Charles S. Hamlin in 1914, preceded Janet Yellen as Fed chair (Figure 1). Each evolved the Fed in response to the issues of the day, and today the Fed operates in a vastly more complex system than it once did. Yet, there are constants, and the central bank's ultimate raison d'etre as a lender of last resort is as clear as ever.

The Federal Reserve characterizes its duties into four main categories:

1. Conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long-term interest rates

2. Supervising and regulating banking institutions

3. Maintaining the stability of the financial system and containing systemic risk that may arise in financial markets

4. Providing financial services to depository institutions, the U.S. government and foreign financial institutions, including playing a major role in operating the nation's payments system

The Fed has carried out these duties for decades, and despite much change, including at the helm, continuity and the power of the institution take precedent. This is true today more than ever, because after a century of experience encompassing the Great Depression, World Wars, financial crises, globalization and complex changes to the financial system, the nation's central bank has evolved accordingly and it can draw from its experiences. Much of the Fed's future conduct will therefore be dictated by its past.

The Power of the Institution

When Janet Yellen was nominated Fed chair, many focused on how she differed from her predecessor, Ben Bernanke. Many still do. This is appropriate but only to a point. When Janet dons her cloak as Fed chair, her actions will be guided by powerful precedents, including the central bank's plethora of experiences, the institutionalization of its processes, its success in acting as a lender of last resort and its hard-won gains in achieving price stability.

Two questions need answering. First, what is engrained in the Federal Reserve as an institution that will guide Janet Yellen as she carries out the Fed's duties? Second, is Yellen bigger than the institution, her position as Fed chair or the financial markets? The answer to the latter question is: Of course not! So, stay focused on the institutional elements that will guide the Fed chief's policies.

Here are six of the most prominent of these elements:

Culture of collegiality: For an organization filled with 200 ambitious Ph.D.s, the Federal Reserve is surprisingly collegial, and Janet Yellen is described as Miss Collegiality. The Fed's top minds, many of whom are staffers advising the Fed's top brass, work together in a flat structure to formulate the best possible policies.

Decision by committee: Arguably one of the least effective chairmen was G. William Miller, who was Fed chief for just 17 months from 1978-1979. His belief that high inflation would self-correct was unpopular at the Fed. In fact, the Board of Governors in 1979 voted against Miller in favor of raising the discount rate. That experience reinforced the importance of the Fed chair forming a consensus and honoring decisions by committee. Dissents since then have been relatively low. To be sure, the Federal Open Market Committee (FOMC) often coalesces around the chairman's views, but the chairman never decides on his own.

Diverse and robust structure: It's called the Federal Reserve System for a reason. The System comprises the Board of Governors and 12 regional Federal Reserve Banks. The Board and Reserve Banks share many responsibilities, including supervising and regulating banks and providing banking services. Reserve Banks themselves have robust structures, and they provide important input to the FOMC on the economy. The Board consists of seven members appointed by the President of the U.S. and confirmed by the Senate. The Board combines with five Reserve Bank presidents to form the FOMC. Board members have permanent votes, but there is an annual rotation of four Reserve Bank presidents (the president of the New York Fed has a permanent vote), ensuring a diversity of opinions. Moreover, nonvoters participate at FOMC meetings.

Dual mandate: The Fed can't stray far from the objectives Congress gives it, which are stated as follows in the 1977 amendment to the Federal Reserve Act:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.
Today, unemployment (and under-employment) is elevated and inflation is near its lowest level since record-keeping began in 1960 (Figure 2), which is why Yellen's Fed can be patient in reducing its highly accommodative stance on monetary policy.

Crisis-ready: In response to the financial crisis, the Fed created a wide variety of credit and liquidity programs known as "alphabet soup" programs because of their acronyms. These tools are at Chair Yellen's disposal to help her and the Fed navigate through a variety of challenges.

Hard-won gains in achieving price stability: In contrast to the 1970s, today the Federal Reserve has enormous credibility as an inflation fighter. The proof? Despite all of the Fed's money printing, consumer surveys indicate household inflation expectations are low. Even more convincing is the $1 trillion market for Treasury Inflation-Protected Securities (TIPS). It shows investors expect the consumer price index to increase just 2.27% over the next 10 years. Low Treasury yields show further confidence in the Fed. Janet Yellen has contributed to this confidence, voting as a member of the FOMC to increase interest rates 27 times. Yellen is no G. William Miller!

The first woman Fed chair understands the important role that price stability plays in fostering economic and financial conditions that promote strong labor market conditions. Mind you, the attainment of price stability means protecting also against an inflation rate that is too low, which is why today's low inflation rate (Figure 2) will be one of Janet Yellen's most important guiding lights.

Winston Churchill Had It Right

There is nothing wrong in change, if it is in the right direction. To improve is to change; to be perfect is to change often.
--Winston Churchill, June 23, 1925, House of Commons

Change can be unsettling and it creates uncertainty, but when an organization such as the Fed has the structure, processes, and experience to carry on and take on new challenges, it can thrive and improve its ability to take on whatever comes its way. Janet Yellen enters a position shaped by 100 years of experience, and is well prepared to lead the Fed through the next set -- a comforting thought for investors. Good luck, Janet!
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