What Will Yellen Do?

Analysts are prone to labeling every upward movement in financial markets a bubble these days (we have all heard enough about the bond market bubble, the stock market bubble, the tech bubble and the Bitcoin bubble, haven’t we?). Meanwhile, rumors are doing the rounds that the Chinese and European economies may be slowing down.

But while investors have good reason to be panicky about where markets and commodities (including the virtual ones) are headed, it seems that what investors are really concerned about at the moment is one simple question: What will Janet Yellen do once she takes over from Bernanke as chief of the US Federal Reserve?

For over four years, the Federal Reserve has stimulated the economy by purchasing bonds worth $85 billion each month. But the Fed cannot keep injecting money back into the economy at this rate forever, and the expectation has been that it will pull the plug on the program at some point in the near future.

And, with just a little over two months left before she takes over, analysts are eager to know if Yellen will maintain her dovish stance on the Fed’s quantitative easing program.

Expectations have changed since Yellen’s tirade against critics of the program in November, and the market is now hoping that she will allow the Fed to continue trying to resuscitate the economy.

Yellen undoubtedly hopes that quantitative easing will boost consumer and business confidence, make them more willing to spend, and thereby create a multiplier effect in the economy, which will catalyze it as it corrects itself. She may be reluctant to raise interest rates because of the still-high unemployment rates, and because she believes that the economy has the potential to do much more. Yellen cited October’s inflation rate of 1% – which was lower from the preceding month and the six-month average of 1.48% – as reason enough for the Fed to continue its quantitative easing program.

But her plan to keep the quantitative program going may be her toughest challenge in office. Critics like Republican Senator Mike Johannes are saying that the low interest rates are pushing the US markets to “a sugar high”, and that he “sees asset bubbles” in the economy.

Yet Yellen believes that the slack in the economy, as indicated by the high unemployment rate and stagnant wage growth, will not allow prices to rise sharply. And while she is optimistic about the potential of quantitative easing and its consequential impact on the economy, Yellen is not oblivious to the risks associated with the policy. She has acknowledged that the economy needs to be watched very closely for signs of asset bubbles, while reiterating that currently, she sees none.

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