Janet Yellen woke up from her nightmare sweating profusely.
While she had kept her chin up, the last year hadn’t been exactly easy. First, it was months and months of waiting to be nominated. Though Larry (Summers, that is) was eminently qualified as an economist to be the Fed Chair, in her mind, given her demeanor and experience, she was a better match. She was surprised POTUS didn’t see it that way. Anyway, that is ancient history. Lately, she missed Ben Bernanke a lot. Carrying the water for the Fed with no one to support her as she had done for the former Chair, especially in light of Williams and Bullard changing their tune with respect to timing of the tightening, was getting old. To make matters worse, her long-time neighbors in DC were upset with her security detail and entourage. She pined for simpler days.
But that was not the cause of her most recent nightmares. No. These nightmares involved a bearded old guy just going on and on, berating her, excoriating her. “How could you, Janet, how could you? Et tu? You know you are responsible. You know, don’t you?” For the longest time, not being able to recognize the man had vexed her.
This had been going on for quite some time now. Tonight, Janet awoke with a sudden realization that the old guy was Paul Krugman! In her nightmare, Paul was doing to her what he had done to the Mankiws and the Rogoffs of the economist world: showing the world the emperors had no clothes.
Krugman, in the nightmare, was furious at Janet that the U.S. economy had accelerated in the second half of 2014 and the Fed, under her leadership, had capitulated and tightened policy. As a result, the U.S. economic expansion, which had been gaining sustainable traction, went into in a tailspin and never recovered. In turn, the global economy, counting on the only engine that was functioning properly, got into a tizzy. There was no financial crisis, for sure, but global growth lost its recovery oomph and just deflated. It was 1938 all over again.
After a bit of reflection on her nightmare, Janet Yellen sat up, had a sip of water, relaxed a bit, and tried to go back to sleep. She realized that while the nightmare was a good reminder of how things could turn, there was no sense worrying about it too much. She knew better. She understood the risks that Krugman, in her dream, was berating her about and she knew she simply wouldn’t let those things happen. Not on her watch.
From her perspective, in hindsight, setting up the parameters for policy tightening in terms of the unemployment rate was a mistake. Focusing on just unemployment in the U.S. to set the policy for the world’s central bank, especially while deflationary winds continue to blow all over the world, was just bad framing. But what’s done is done, and she couldn’t do anything about that now, other than just plain reject the implications on inflationary grounds. Yes, she will go around and keep telling everyone that the unemployment rate in the current framework is somewhat irrelevant for wage-growth-driven inflationary pressures. There was too much play in the participation rate for that to be the case. There is no wage inflation in the U.S. or any developed market, and as long as that remains true, there is no reason to tighten, unemployment rate notwithstanding.
In her mind, the advantages of a policy tightening in a world awash in savings and modest capital demands are paltry. Even if she nudged up the Fed Funds rate to a percent or two, the impact on the long end of the curve would likely be minimal anyway. That is driven by the demand and supply of savings. And, on a global basis, there is an excess of savings. What the world lacks is aggregate demand. Policy tightening is not going to help that.
On the other hand, the downside of policy tightening could be significant. In addition to the 1938 analogy of a nascent recovery snuffed out by too hasty a policymaking, her concerns included the potential impact on the Japanese, European and EM economies. While she fully realized that supporting overseas economies is not part of her mandate, she also understood that in a world in which supply and demand of savings and aggregate demand were truly global, she could not serve her own country effectively without considering the world economy. What happens in Rio, economically, impacts Richmond, even if the Chair of the Richmond Fed does not care.
Janet knew that the price of haste in policy tightening would be too high, and the potential benefit very small. No, not worth it.
No reason to worry about Krugman too much. He’ll most likely only berate her in nightmares, and not in real life. Why waste precious sleep on him?