To many investors and economists, the prospects for a new Federal Reserve chief became clearer – and brighter – after former Treasury Secretary Lawrence Summers dropped out of contention for the post.
The same can’t be said for the lackluster U.S. economy.
Even if economist Janet Yellen, now the Fed’s vice chair, gets the nod as the next leader of the central bank, she will inherit a job that is getting only more difficult.
With productivity gains weak, the housing market showing signs of cooling, and another nasty Washington fight looming over the debt limit and the budget, Yellen and her colleagues are looking at a very uncertain economy during their two-day policy-setting meeting, which ends Wednesday.
Since the recovery from the Great Recession began more than four years ago, the central bank has consistently overestimated the pace of economic growth in the nation. And the economy is again underperforming the Fed’s projections for this year.
“It’s not an easy time, and it’s not going to get any easier” for the next Fed chair, said Diane Swonk, chief economist at Mesirow Financial. “I wouldn’t wish it on my biggest enemy.”
The persistently weak economy has prompted the Fed under Chairman Ben Bernanke to inject an unprecedented amount of cash into the financial system. Policymakers on Wednesday are expected to announce just a small reduction in the central bank’s $85-billion-a-month bond-buying stimulus program.
Fed officials are likely to try to offset what some may perceive as monetary tightening, by signaling that it will keep short-term interest rates near zero even longer than mid-2015, the current projection.
Still, any cut in the Fed’s stimulus efforts is a bet that the recovery – and the employment market in particular – will strengthen in the coming quarters. But the Fed’s own projections cast doubt on that bet.
The economy grew at a disappointing annual rate of less than two percent in the first half, and the current quarter isn’t looking any better – making it likely that the Fed on Wednesday will revise down its previous forecast of 2.3-2.6 percent expansion for this year.
Such moderate growth doesn’t bode well for acceleration in job growth, which has been modest.
Summers was President Barack Obama’s chief economic advisor in 2009-10 and a key figure in the administration’s response to the financial crisis.
Known as brilliant but combative, he was Obama’s top choice for the Fed. But Summers withdrew his name Sunday, in the face of sharp criticism from many Democrats and strong doubts that he could win confirmation in the Senate.
Many analysts believe Yellen is now in the driver’s seat for the nomination. But senior administration officials said Obama was upset about the unprecedented public lobbying by Yellen supporters that helped trigger Summers’ decision, and he could turn to a third candidate.
In speeches, Yellen, a former president of the Federal Reserve Bank of San Francisco, has expressed strong concerns about the weak labor market.
Investors believe she would be more prone to prolonging the Fed’s easy-money policies than would Summers, whose views on monetary policy are less known, but who is nonetheless seen as more concerned about inflation risks.
Economists point out that whoever gets the top Fed job will face tough challenges, especially if the economy doesn’t pick up.
One difficulty is that the Fed has to engineer the tapering of its bond-buying, and the eventual disposal of about $2 trillion in U.S. Treasury bonds it has purchased.
That tapering also could be hampered by the economy’s failure to live up to the Fed’s expectations.
The Fed’s latest projection in June has growth accelerating next year to as much as 3.5 percent.
The U.S. economy could get a boost from a reviving Europe and a Chinese economy that seems to be stabilizing. Domestically, American corporations are raking in large profits, and U.S. households are in much better financial shape, having cut back debts and recovered a large part of the wealth lost in the Great Recession.
Yet most Americans haven’t felt real income gains, and government spending cuts have hurt the economy.
Particularly disconcerting for the Fed is the recent slowing in the housing market recovery, as mortgage rates rose sharply in recent months from near all-time lows.
Anticipating the end of the Fed’s easy-money policies, which have kept interest rates low, investors have driven up rates for a 30-year mortgage by more than one percentage point since May, to 4.57 percent last week.
The rate remains low by historical standards, but the rise has weakened buying and refinancing activity, which had helped boost the economy in the first half of the year.
With the drag from higher long-term interest rates, Macroeconomic Advisers, a major forecasting firm, projects that the economy will grow 2.7 percent next year, down from its forecast of three percent a month ago and well below the Fed’s estimate.
“I’m hoping the housing market has greater momentum,” said Swonk, noting that it will be a key factor in shaping the economic outlook.
Another threat to the economic recovery looms in the coming weeks, when Congress must pass a spending plan by Sept. 30, the end of the fiscal year, or face the prospect of a federal government shutdown.
Lawmakers are wrangling with the White House, with many Republicans refusing to approve any budget bill that does not eliminate money for President Barack Obama’s health care law. A shutdown would deprive the economy of federal spending, hampering growth.
Complicating matters, the nation is forecast to hit its debt limit around the middle of October. Republicans are balking at raising the $16.7 trillion limit, unless there are significant spending cuts.
Failure to raise the debt limit would trigger a first-ever federal government default and roil financial markets.
Washington gridlock over the issue, in the summer of 2011, wreaked havoc on financial markets and sapped economic momentum. Economists fear a repeat scenario – or worse, this time.
“The Fed could be forced to reverse gears if the market is roiled enough by what’s going on,” said Gary Schlossberg, senior economist at Wells Capital Management.
Given the Fed’s already extensive intervention, which has sparked political controversy and fears of soaring inflation and asset bubbles, it won’t be easy for it to do much more. Fed officials themselves are not so sure that continued bond buying will be effective in stimulating the economy.
“The next Fed chairman’s big problem is that [the Fed has] experimented with monetary policy with somewhat limited success, and the economy is not terribly robust,” said John Makin, a monetary policy expert at the American Enterprise Institute, a conservative-leaning think tank.
“If the economy doesn’t get better, as the Fed’s forecast says it’s supposed to, they’re in a very tight spot.”