What Fed's Monetary Policy Could Look Like Under New Leadership

With news that President Obama will nominate Janet Yellen as the next chair of the Federal Reserve (to replace Ben Bernanke when he steps down on January 31, 2014), I think it’s important to take a look at how monetary policy could change under her leadership.

Yellen has been part of the Federal Reserve system for quite a long time. In one sense, the market will see her as a continuation of the current monetary policy initiatives, as she has been quite close with Bernanke, helping shape the viewpoint of the current Federal Reserve on monetary policy.

Generally speaking, Yellen is considered more dovish (willing to extend low interest rates) than other potential Federal Reserve candidates. In this respect, it’s expected that many sectors of the economy and markets that have benefited from the current monetary policy may continue to benefit for a longer time frame than if another person were elected as leader of the Federal Reserve.

While we all know that at some point the Federal Reserve will begin to reduce its aggressive monetary policy stance, the timeline could be extended. Obviously, this is all just speculation, but Yellen has been vocal in the past about maintaining an aggressive monetary policy stance until the economy really begins to accelerate.

But as dovish as her reputation is, many people don’t know that she was actually one of the first Federal Reserve members to speak up about her concerns regarding the bubble in the housing market back in 2007.

This dichotomy is interesting: on the one hand, she is one of the most aggressive Federal Reserve members currently pushing for easy monetary policy (which goes hand-in-hand with low interest rates); on the other hand, back in 2007, she was one of the first to be concerned about the fact that the low interest rate environment could cause housing prices to fall.

Given Yellen’s stance on the housing market situation in 2007, can we expect the Federal Reserve to be more accurate in their forecasts of the economy under her leadership?

Generally speaking, any organization or person cannot see the future; they can only predict it, so forecasts, in general, should be taken with a grain of salt. The Federal Reserve does have a history of being optimistic regarding its forecasts, yet Yellen was correct in calling the drop in home prices prior to the housing crisis.

Is she correct in her forecast that the current U.S. economy remains weak and requires further monetary policy help?

The inaction by the Federal Reserve during the last meeting seems quite prescient, as we have seen some data recently pointing to economic weakness in the U.S. economy. It certainly doesn’t appear that our economy is accelerating, especially as jobs growth remains quite muted at this point in the economic cycle.

While I do agree that the U.S. economy remains weak, and this current fiasco in Washington certainly isn’t helping, there are growing dangers that the current monetary policy program might result in side effects that are more detrimental than many people estimate.

It’s a much more difficult situation than many people think, since calls for a complete reverse of the current monetary policy program would mean a huge increase in interest rates, which would certainly choke any economic growth. But keeping the aggressive monetary policy plan in place means a potentially larger cost over the long run.

What I think we should remember is that while Yellen is more dovish, at some point a reduction in monetary policy will begin, which will mean higher interest rates. As I’ve been stating for all of this year, expect higher interest rates over the next decade. This means that if you have bond mutual funds, you should expect to see the value of these investments continue to drop over time.

What is certain is that the next Federal Reserve chairwoman will face a huge amount of scrutiny and difficult choices. Generally speaking, I think the sooner we return monetary policy to a more normal, historic level the better it is for the future of America.

This article What Fed’s Monetary Policy Could Look Like Under New Leadership was originally published at Investment contrarians