There is little, on the surface, to object to in Janet Yellen’s statement that if it looks as though government spending is leading the US economy to overheat the Federal Reserve may have to raise interest rates. As a description of the job of an independent central bank it was admirably concise. It was also conditional: she did not say the economy would overheat, only what the Fed should do in response. Nonetheless, it was still unwise to say it.
The remarks, at an event hosted by The Atlantic magazine, sparked controversy and led to a sell-off in stock markets that have come to take cheap money for granted. Tech stocks, particularly sensitive to interest rates, dropped the furthest, albeit still modestly. The S&P 500 closed down 0.7 per cent on Tuesday, while the more tech-focused Nasdaq ended down 1.9 per cent. There is no great tragedy here: investors ought to be aware that today’s high valuations depend on certain assumptions about the path of interest rates. Those assumptions can always turn out to be wrong, and if anything Yellen’s comment may be a salutary wake-up call.
While the content may have been obvious, it is not advisable for a Treasury secretary to comment on monetary policy. Plenty of holders of the office have tried to use “open mouth operations” to influence monetary matters — including the value of the dollar relative to other currencies; it has rarely worked out well. The uneasy compromise between the US Treasury and its central bank — dating from the accord of 1951 — requires each to respect the other’s role. Plenty have not: President Richard Nixon intimidated his Fed chair in the 1970s to try to keep rates low; Alan Greenspan, a former Fed chair, inappropriately endorsed tax cuts in the early 2000s.
Overall, in this company, Yellen’s comments were not particularly egregious. But it is telling that she still felt the need to clarify them, saying later that she did not think there would be an “inflationary problem” and that “if anybody appreciates the independence of the Fed, I think that person is me”. Either way, the comments contained something for markets to react to.
They suggested the Biden administration is not entirely convinced by the arguments of economists and commentators that the economy should be “run hot” to draw new groups into the workforce, reduce inequality and encourage companies to invest in labour-saving technology. This will disappoint many of those who had hoped it would represent more of a break from the past few decades of economic orthodoxy, on monetary policy as well as fiscal policy — although the small rise in rates that Yellen has in mind would still keep policy loose.
It was also politically inadvisable to give ammunition to those opposed to the spending package Yellen is trying to get through Congress. Those worried about the size of the package can quote back her words on the risk of overheating. Of course, it would not be a disaster for central banks to be able to increase interest rates from record lows and retreat slightly from the extraordinary monetary policies they have been pursuing for over a decade. Many are concerned the downsides of these policies are now outweighing their benefits.
Whether or not the spending package will lead to an overheating economy is a judgment call: no one knows the extent of the damage done to productivity by the pandemic or what it would take to change inflation expectations. Sensible economists know this, and Yellen is nothing if not a sensible economist. Her new career, however, will sometimes require her to behave instead like a sensible politician.