James Saft, Reuters Columnist
Markets celebrated on Monday after Summers, facing strong opposition to his confirmation should he be appointed to succeed Ben Bernanke as Federal Reserve chairman, wrote to President Obama saying he no longer wished to be in the running. Equities jumped and bond yields fell because investors see Summers’ exit as opening the way for Fed Vice Chair Janet Yellen, who in turn they expect to hew closely to the policies followed by Bernanke.
Yellen is seen as a gradualist who would only very slowly taper bond buying, a process that may well begin this week, and who is less likely to rapidly withdraw other support from the economy.
That’s good for riskier investments in a strictly mathematical way, in that the point of bond buying is to drive investors to take the cash they get from the Fed for their bonds and buy other, more speculative things.
Why the bond market grew to fear Summers so much is also interesting, and sheds light on why we all ought to be glad he won’ be nominated. As the summer wore on and talk of his likely nomination heated up, despite cries of despair from some quarters, bond yields became quite tightly correlated with his fortunes, rising when it looked good for Larry and falling when it didn’t.
That was partly, of course, due to Yellen, who would only cautiously withdraw support, but it was unclear how much was to do with Summers. After all, he has been very tight-mouthed about his views on monetary policy, only hinting at concerns about quantitative easing and low rates.
I think investors, having lived through the crisis, recognized in Summers the kind of unrepentant over-confidence which did so much to engender it in the first place. While everyone acknowledges the man’s brilliance, he has a strong track record of staking too much on his own analytical ability, and of failing miserably by so doing.
Larry’s very big bet
Think, for example, of his wager on interest rates while President of Harvard in the early part of the last decade. During the crisis this bet came undone, costing the university more than $1 billion, according to published estimates.
That this was done with money from the operating budget, which usually is treated far more conservatively, and was done over the objections of more qualified staff, is only more evidence that Summers is prone to taking the kind of big bets on his own initiative that quite rightly terrify bond investors.
This is not the behavior you want from a central banker running what is already highly experimental policy in extremely uncertain times.
Put simply, we must hope Yellen, if she gets the job, is appropriately cautious and appropriately humble about the limits of a central banker’s power and knowledge.
The very idea of the taper has to be seen as a tacit acknowledgment that extraordinary monetary policy may not be working, and that to the extent it does work, it unfairly redistributes wealth while risking bubbles which act as a cost on all.
There is simply no way to look at the Fed’s dual mandates of inflation and employment and conclude that a taper is justified on the fundamentals. Both inflation and employment are well off target and neither is doing a convincing imitation of an indicator on the mend.
The taper, and it looks like we will get one either on Wednesday or later this year, is a risk management exercise in which the Fed, like a wise poker player, takes a bit off the table because it is a bit less confident in its hand and in its ability to read those of its opponents.
That’s right and proper but by definition must be tentative. First, once markets realize the Fed has doubts about bond buying they may move too fast for comfort, driving up yields and hitting equities in a damaging way.
Second, the Fed must give the impression that it will respond appropriately in either direction as events unfold. Not that they, Larry Summers-style, have brilliantly deduced the answer and will beat the rest of us to the spot. Rather, that they will move slowly and prudently. Yellen seems as well equipped as anyone to play that role.
Quantitative easing may turn out to be like climbing a tree: going up too far is unwise, but getting down too quickly is even worse.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)