Yellen at the Helm: Where to From Here?

Janet Yellen, the new chair of the Federal Reserve, holds one of the most powerful positions in the world. Fed decisions to cut interest rates (add accommodation) can create trillions of dollars in new wealth in a matter of days. Conversely, decisions to raise interest rates can create recessions and massive layoffs.

The Fed is considered to be politically independent, but the Fed chair is appointed by the president. In his last press conference in December, outgoing Fed Chair Ben Bernanke was compelled to remind Yellen that “Congress is our boss.” The chair reports to Congress twice a year on the Fed’s activities.

The Federal Reserve can earn profits from interest on bonds that it owns. Since the Fed began operations in 1914, it has remitted about 95 percent of its net earnings to the Treasury. In 2003, it paid approximately $22 billion and in 2012 a record $88.4 billion in profit. When interest rates start to increase, these profits can turn into losses. Yellen will work hard to maintain the perception that the Fed is indeed independent from Congress and the White House because this will reassure the public that the huge federal deficits will not be allowed to create runaway inflation in the future.

The Fed’s Mission

Created by Congress in 1913, the Fed was a response to the financial panic of 1907, also known as the “1907 Bankers Panic.” The stock market fell nearly 50 percent, and there were numerous runs on banks. One very wealthy man at the time, J. P. Morgan, pledged large sums of his own money to calm the financial panic. Congress felt vulnerable knowing that the entire American financial system could have collapsed without the intervention of one man, so it created the Fed. Its mission is to provide the nation with “a safer, more flexible, and more stable monetary and financial system.”

One hundred years after its creation, the Fed has two mandates from Congress: maximize employment and maintain stable prices.

When unemployment is too high, it keeps interest rates low for a long time, which usually causes stock prices and home prices to increase. Hence, those who own stocks and houses get wealthier and are more likely to buy things. In a 2005 speech, Yellen discussed this issue, saying:

“Monetary policy affects the economy not primarily through short rates but instead through its effects on asset prices, including bond rates and equity prices. If financial markets have a good understanding of the central bank’s objectives and strategy, they will react appropriately to policy moves.”

Low interest rates also encourage people to take out loans to buy cars and boats and take vacations. These activities create jobs. The Fed will want to keep interest rates low until it feels that America has reached “full employment.”

The second mandate, to maintain stable prices, can be described as keeping inflation from increasing above 2 percent per year. When the economy has reached full employment, prices can start to increase faster. When the inflation rate rises above 2 percent for a sustained period, the Fed may begin to increase interest rates to reduce economic activity. This has been referred to as “removing the punch bowl from the party.”

Yellen became Fed Chair after the worst recession since the 1930s. Unemployment is high and inflation is very low. This scenario suggests that the Fed will keep interest rates low for a long time. The low interest rates have pushed stock markets to record highs and have contributed to significant home price increases. The U.S. economy is recovering, and unemployment has now fallen to 6.7 percent. As the economy continues to improve, the Fed will begin to allow interest rates to rise to a more “normal” level.

Many real estate professionals and investors are studying this issue intently, knowing that rising interest rates can have an impact on residential and commercial real estate sales volume and price trends.

Nobody could have guessed that Americans would be able to buy a home with a 3.5 percent mortgage rate. That was an historic gift from the Fed in an earnest attempt to repair the damage done to the housing market. To offer some perspective, the average 30-year mortgage rate was 8.9 percent in the 1970s, 12.7 percent in the 1980s, 8.12 percent in the 1990s and 6.29 percent in the 2000s.

Higher interest rates will not only cause home mortgage rates to increase but will also increase borrowing costs for commercial real estate (CRE) investors. As their borrowing costs increase, the net income from CRE buildings will decline. Additionally, as the interest rates on bonds increase, the expected investment return on real estate will move up as well. This could create downward price pressure on CRE property values.

The biggest unknown is when the Fed will start to increase interest rates. In other words, how low will the unemployment rate have to get before rates are increased? In a 2008 speech, Yellen remarked that:

“Slower economic growth has pushed up the national unemployment rate to 6.1 percent — over a full percentage point above the level that, in my view, is consistent with “full employment.”

This indicates that she views a 5 percent unemployment rate as full employment. Unless she’s changed her mind, expect her to keep the Fed Funds rate low until we get to that point. Recent remarks have indicated that she would keep interest rates “lower for longer” than people may expect. Don’t look for interest rates to increase until we get closer to a 5 percent unemployment rate unless consumer price inflation moves above 2.5 percent for a sustained period.

The Fed’s second mandate, price stability, will keep interest rates low to help the economy grow as long as inflation stays “well behaved.” In a 2008 speech, Yellen enunciated her views on acceptable inflation rates:

“The core PCE Price Index rose by 2.5 percent over the past 12 months, which is somewhat above the range that I consider consistent with price stability. . . .”

Another issue that Yellen considers of keen importance is credibility. She notes that Americans and investors all over the globe must have confidence that the Fed will not tolerate or allow sustained high rates of inflation. Fed pronouncements on occasion assert that inflation expectations are “well anchored.” What this means is that global investors still have confidence that the Fed will not allow inflation to get out of control. In her words:

“Credibility is all about what the public expects the Fed will do in the future.
It is only when the Fed’s commitment to low inflation is credible that people will expect low inflation in the future and set prices accordingly.”

In a 2009 speech, she clearly staked her position as a defender against runaway inflation with these words:

“Let me be unequivocal. The Fed is committed to doing everything in its power to foster recovery while maintaining price stability. When it’s necessary to withdraw the extraordinary stimulus we have put in place, we won’t hesitate.”

This is why it will be important for Yellen to establish a reputation of maintaining independence from Congress and being diligent not to let things get out of hand. Credibility comes from communication and transparency. The Fed is going to do its best to let people know what it is doing and give some benchmarks as to when it will make its moves. The Fed is like a large boat that throws out a large wake. When that big boat makes an unexpected move, a lot of small boats can get swamped. Communication is important to Yellen. Expect her to do her best to communicate the goals and policies of the Fed clearly so the market can correctly anticipate Fed actions.

Asset Price Bubbles

One byproduct of low interest rates over a long period can be asset price bubbles. In the past three years we have seen record high prices in gold, farmland, stocks and bonds. House prices have increased rapidly in the past two years. Higher interest rates in 2013 burst the price bubble in gold and the bond market. Some market analysts wonder if the Fed will increase interest rates solely for the reason of stopping a bubble in the housing market or the stock market.

The Fed suspected there was a price bubble in the stock market as early as 1996 but chose not to burst the bubble with higher interest rates. Instead, Greenspan tried to warn the public about “irrational exuberance” in the stock market. The market increased substantially for another three years before it experienced a major correction in 2000.

In a 2005 speech, Yellen addressed the issue of using monetary policies to stop the forming bubble in the housing market. She noted that the share of residential construction in GDP was at its highest level in decades, and that the price-to-rent ratio was about 38 percent above its long-run average. She remarked:

“It’s obvious that the housing market sector represents a serious issue for monetary policy makers to consider.”

Her conclusion was revealing:

“. . . it seems that the arguments against trying to deflate a bubble outweigh those in favor of it. So, my bottom line is that monetary policy should react to rising prices for houses or other assets only insofar as they affect the central bank’s goal variables — output, employment and inflation.”

Dr. Dotzour ([email protected]) is chief economist and Kokel and Parulian are research assistants with the Real Estate Center at Texas A&M University.