President Barack Obama was recently asked what kind of person he is looking for to head the US Federal Reserve. His answer: someone who will help the economy grow while keeping inflation in check and making sure we do not create new instabilities in financial markets. I think that is an excellent assessment of what we need, and a good summary of why Janet Yellen, the Fed’s current vice-chair, would be the right choice.
Ms Yellen was one of the first Fed officials to see the problems developing in the US housing market. In late 2005, for example, when she was president of the San Francisco Fed, she explained her concerns about the housing market. “If house prices fell,” she warned, “the negative impact on household wealth could lead to a pullback in consumer spending. Certainly, analyses do indicate that house prices are abnormally high – that there is a ‘bubble’ element.”
Many respected analysts, within and outside the Fed, did not share her appreciation of what was going on. In August of that year, Professor Raghuram Rajan of the University of Chicago presented a paper at the Fed’s Jackson Hole conference that proved to be a prophetic analysis of the problems developing in financial markets. He warned that the combined effects of deregulation, complicated new financial products, and the overreliance of the financial system on short-term borrowing had produced a fragile environment, suggesting that incentives for excessive risk-taking could lead financial managers to “follow the herd into disaster”.