Chandler Bond Market Review

Who’s Next? Filling the Chair at the Fed

The term of current Fed Chair Ben Bernanke ends January 31, 2014.  The President has said he is likely to make an appointment of the new Chair this fall; an appointment that will have to be vetted and consented to by Congress.  There has been considerable analysis and opinion in the financial and political press of late about who will succeed Bernanke as Chairman of the Federal Reserve.  Mr. Bernanke, who has led the Fed since 2006, began a welcome policy of transparency regarding Fed thought and actions, for which he will long be remembered.  Perhaps higher in the ranks of current thinking about his tenure, is that he  imposed the drastic monetary policies known as “Quantitative Easing,” QEs 1 through 4, which have worked well to bring the US out of the financial meltdown of 2008 and the “Great Recession” of 2007-2009. Since that time, the unemployment rate has gone from a high of 10% in October 2009 to its July 2013 level of 7.4%, while inflation has remained in check, as the chart below shows.

Inflation and Unemployment

Like most seemingly successful strategies, QE came at a price—the expansion of the Fed’s balance sheet.  The mechanism for implementing QE was the Fed’s purchase of an immense amount of US Treasury and mortgage debt.  The goal was to take so much of the supply of high quality debt out of the market that scarcity would bring prices higher, and concomitantly bring interest rates down.  The low interest rates would then stimulate borrowing and help bring the economy back from the brink.  Furthermore, extremely low rates on high quality fixed income debt created significant demand for higher “beta”, i.e., riskier, asset classes.  As these riskier asset classes, primarily equities and foreign debt, increased in value, consumer balance sheets (particularly IRAs and other retirement savings accounts) began to look much stronger.  The net effect was that consumers, with a cushion of savings and normalizing home prices began to feel comfortable spending again. 

We have shown this Fed balance sheet several times before in our Newsletter, but let us look at it again:

Fed's Balance Sheet

Fed assets jumped vertically from less than $1 billion to almost $2.5 billion as the crisis began to unfold in 2008.  After the initial leap until the present time, assets continued to climb, albeit more gradually, to the current level of approximately $3.5 billion.

Most market observers believe (and hope!) that over the next few years, the economy will continue to expand, perhaps even at an accelerated pace, and that inflation will remain contained.  If the future unfolds in that way, the main focus of the new Fed Chair is likely to be the controlled unwinding of QE.   The period of QE unwinding is likely to be both delicate and treacherous.  The Fed’s twin mandates of full employment and constrained inflation can be at odds, and thus difficult to achieve during the expected unwinding of QE over the next few years.  

Given that critical task, who might be the best candidate to lead the Fed next?

Janet Yellen

At this point in the process, the clear leader among market prognosticators is Janet Yellen. 

Dr. Yellen is an experienced economist and a veteran at the Fed.  She earned her PhD in economics at Yale in 1971 and taught at Harvard University before becoming an economist at the Fed.  Since 1980, she has taught macroeconomics to MBA students and done research at UC Berkeley.  She served as Chair of President Clinton’s Council of Economic Advisers for two years, and was Chair of the Federal Reserve Bank of San Francisco and a voting member of the Federal Open Market Committee (FOMC).   She currently serves as a Fed Governor and as Vice-Chair of the Federal Reserve System. 

Yellen has been seen as a Fed “Dove,” meaning that she is more concerned with unemployment than with price stability. She might be slower to reverse QE than other candidates for the job; perhaps boosting employment while risking higher inflation. Still, in recent years, she has made more balanced statements and is highly regarded within the Fed.  

Lawrence Summers

The second major contender is Lawrence Summers, former Treasury Secretary under President Obama, as well as Obama’s Director of the National Economic Council.  He is somewhat more outspoken than Yellen and is viewed as provocative, or even polarizing.  His credentials for taking on the Chairmanship include his work as an economic adviser and Treasury secretary under President Clinton, and his close relationship with President Obama as an adviser.  Currently, he seems to be more constructive than Yellen about US near-term economic prospects.  Market fears around Summers may be geared more to an unwinding of QE that is too quick, thus presenting a risk to economic growth. 

The Field

Other possible candidates include Donald Kohn, a 40-year veteran of the Fed; Roger Ferguson, an Obama adviser and Chair of the bank supervision committee of the FOMC; Christina Romer, another Obama economic adviser; Alan Blinder, former Vice-Chair of the FOMC; Tim Geithner, former Treasury Secretary and President of the New York Fed; and, finally, Ben Bernanke himself—the current Chair and father of QE may be the best person to undo QE. 

The next Chairman of the US Federal Reserve, whoever it may be, will face the challenge of developing monetary policies that will invigorate a US economy that is tepid now, and maintain inflation  at an acceptable level, while, at the same time, unwinding the Quantitative Easing that is one of the hallmarks of Ben Bernanke’s tenure as Fed Chair. 

 

– Kay Chandler

        President

 

 

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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