Summers-led US Fed might raise rates faster than Yellen

Barring another financial crisis or slide back into recession, the next head of the US Federal Reserve is likely to oversee a gradual normalisation of monetary policy.

But that pace, including the first interest rate hike, might be somewhat quicker under former US Treasury Secretary Lawrence Summers than under current Fed Vice-Chair Janet Yellen, the two top contenders for the job, if their own comments are any guide. Moreover, a Summers-led Fed would appear less likely to extend or expand the use of the extraordinary measures that the central bank has undertaken during the tenure of current chairman Ben Bernanke, whose term expires in January.

 
The distinction between Summers and Yellen is perhaps best illustrated by remarks they delivered at separate events in April. Yellen, a strong supporter of Bernanke's policies, in a speech to business editors in Washington, exhorted the Fed to keep its focus on efforts to foster a lower unemployment rate, even if it comes at a cost of stronger-than-desired inflation.

By contrast, Summe rs, in a separate, closed event in California later that month, raised doubts that the unemployment rate could drop all that much lower without kindling unwanted levels of inflation. He also was sceptical about how effective the Fed's massive bond buying programme, known as quantitative easing, has been in promoting economic growth.

"Both Yellen and Summers are unlikely to commit the mistake of premature policy tightening, and that risk is probably somewhat lower with Yellen than Summers," said Michael Feroli, an economist with JP Morgan in New York.

That said, commitments the Fed has already undertaken make quick changes unlikely whoever gets the job, as St. Louis Fed President James Bullard noted on Thursday.

"I would expect a lot of continuity in policy, and I think any new person coming in would want that continuity. They don't want to come in and really rock the boat a lot. So I would expect a smooth transition," Bullard said in Louisville.

But slight differences in how the new Fed chair views policy could matter a great deal if the economy fails to recover as expected, or if there is a debate about how long to hold interest rates near zero once unemployment has fallen further.

The Bernanke-led Fed has already committed to keeping rates ultra-easy until unemployment hits 6.5 per cent, and at least one official advocates lowering this forward guidance to 5.5 per cent in order to hold down borrowing costs.

Summers might be less inclined to back such a move if the news on the economy continued to be mixed. Yellen's strong support for the importance of driving down long-term unemployment, even if that meant inflation rising a bit, could be more open to such an aggressive move. She has also laid out a so-called 'optimal policy path' that would permit a bit more inflation than the Fed's two per cent goal in order to push down long-term unemployment, which she views as even more damaging to the nation's economic health.

As a result, there is a broad body of public written and spoken commentary in which she has articulated an approach which would not diverge much from the path already laid out by Bernanke, and might even be more dovish.

In contrast, most of Summers' recent comments have been on fiscal policy, where his advocacy for government intervention might infer a readiness to maintain Fed stimulus.

But he has talked about monetary policy on at least two occasions in the last year, and these remarks make clear he is no hawk in the sense of the fierce Fed critics who blame the central bank's dramatic action for stoking a looming inflation.

Indeed, he argued in favour of additional quantitative easing in a Reuters opinion piece published on June 3, 2012.

"Many in both the US and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy inaction to current economic weakness than of overreacting," he wrote.

And in his most comprehensive monetary policy remarks, at an April conference in Santa Monica, California, hosted by Drobny Global Advisors, he explicitly played down the dangers of inflation.

Sceptic
But he also voiced reservations about the benefits of further aggressive bond purchases, saying that "QE in my view is less efficacious for the real economy than most people suppose," according to a transcript of his comments obtained by Reuters.

That view could be significant if the economy fails to recover.

The Fed expects to scale back bond buying later this year and end the programme by mid-2014. It may want to consider delaying that wind-down, or even increasing purchases from a current $85 billion monthly pace, if growth disappoints.

A Summers' Fed might resist extending the programme from worry it will not have much benefit, but carries mounting costs, which he hinted at the April conference by pointing to signs that emerging market credit "is starting to look a little frothy."

That market subsequently has cooled substantially due to signals the Fed is nearing the point of reducing its purchases.

Furthermore, he has also signalled a gloomy view on how fast the economy can expand in the future without overheating, noting that the natural rate of unemployment may have risen and its potential rate of growth may have declined.

"To the extent that view is accepted, it should operate in the direction of leading one to expect the beginning of the tightening phase to happen sooner than is now supposed by many," Summers told the invitation-only event in Santa Monica.

That hint of doubt in his mind about how much slack might be left in the economy if the jobless rate reached 6.5 per cent could translate into a readiness to raise interest rates faster once the threshold is breached.

"He might be more likely than Yellen to support raising the funds rate target soon after the 6.5 per cent threshold is met," said Laurence Meyer at Macroeconomic Advisers.

"We suspect that Summers might be inclined to raise rates more quickly than Yellen after the first rate hike," the former Fed governor wrote in a client note.