Yellen’s Inheritance: Monetary Policy in Flux

Evolving economic challenges are transforming central banking around the world. The new monetary-policy doctrine is likely to put greater emphasis on asset-price developments. But, without a true monetary anchor, central banks could still risk a repeat of the recent boom/bust cycle.

Ben Bernanke, outgoing Fed chairman, recently noted that “central bank doctrine and practice are never static”. He’s right. Institutions that were originally set up to finance government and/or safeguard financial stability now have responsibility for virtually all aspects of economic life. That’s a burden Janet Yellen, confirmed as Fed chairwoman this week, will have to bear as she steers monetary policy at the helm of the world’s most powerful central bank.

The Evolution of Central Banking

Today, central banks like the Fed are expected to keep prices stable, promote high employment and regulate the financial system. And since 2008, they have been forced to inflate their balance sheets to prevent a repeat of the Great Depression.

What drives the evolution in central banking? Changing priorities of government are a big factor. But structural changes to the economy and financial markets have also played an important role. These trends have forced central banks to introduce important modifications to monetary regimes, often interspersed with lengthy transitional phases. In our view, the period in which unconventional policy tools, such as near-zero interest rates and quantitative easing, have been at the forefront of monetary thinking is nearly over. Central banking is about to enter another transitional phase.

In Search of a New Tool Kit

It’s too early to know what the new monetary policy regime will look like. We do know that the transitional phase could be lengthy. And the new framework is likely to involve an even broader mandate for central banks, forcing them to focus on multiple objectives—avoiding deflation and promoting financial stability, with particular emphasis on lower unemployment. This is similar to what happened in the 1960s and 1970s, a period which ended with inflation spinning out of control.

Groping in the Dark

Expect some confusion too—especially regarding central bank reaction functions. In part, this is because policymakers themselves will be groping in the dark. In the short term, though, we think it’s a safe bet to think that monetary policy is more likely to err on the side of being too loose than too tight.

It’s too soon to say whether central banks will be able to avoid the boom/bust cycles of the past. But there are signs they are moving in the right direction. For instance, there is now growing recognition that (consumer) price stability is too narrow a benchmark and that, in the future, central banks will have to pay more attention to asset price developments when formulating monetary policy. This is welcome news: we have long advocated the use of a broad price index—which includes consumer, producer and asset prices—to help identify risks to economic and financial stability.

Will this be enough? Probably not. Our analysis of post-war monetary regimes suggests that the abandoning of monetary anchors during the transition from monetary to inflation targeting in the 1990s was a serious policy error. Until central banks grasp this point and put some form of broad monetary anchor back at the heart of monetary policy, they may unwittingly continue to foster conditions that can lead to dangerous misalignments in consumer and/or asset prices. We fear it might take at least one more costly boom/bust cycle for the world’s central bankers, including Janet Yellen, to learn this lesson.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph G. Carson

Director—Global Economic Research
Joseph G. Carson joined the firm in 2001. He oversees the Economic Analysis team for Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor’s All-Star Team for Fixed Income. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Location: New York

Darren Williams

Senior Economist—Europe
Darren Williams is responsible for economic analysis, interest-rate forecasting and bond market strategy for western Europe. He has covered the major economies of western Europe for over 25 years, and has written extensively on the European Economic and Monetary Union and the monetary policy decision-making process of Europe’s central banks. Williams joined the firm in 2003, having previously held senior positions in the economics departments of several leading investment banks, including Citigroup, UBS and Merrill Lynch. He holds a BSc in banking and finance from Loughborough University (UK). Location: London

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