The economic challenges facing the Yellen-Powell policy duo

The nomination of Janet Yellen for Treasury secretary has been well-received across the political spectrum. Yellen is widely respected in the economics profession for her towering intellect, and her steady guiding hand at the helm of the Federal Reserve during the 2014-2018 period even won the grudging admiration of Wall Street. Federal Reserve Chairman Jerome Powell, who had previously served under Yellen at the central bank, has largely stuck to the monetary policy playbook of his predecessor. With the return of Janet Yellen to the policymaking arena, there is a distinct possibility of a new era of close Treasury-Fed policy coordination.

The Yellen-Powell duo is likely to support additional stimulus, particularly on the fiscal front, to aid the U.S. economy in the short run. Janet Yellen is well aware of the significant role that fiscal policy needs to play in an environment where much of the monetary policy ammunition has already been used up. Besides promising to continue to maintain a dovish monetary policy stance and tweaking its asset purchase programs, there is limited scope for further policy actions from the U.S. central bank. 

The impact on human lives and the health care sector from the third surge in U.S. coronavirus infections is projected to be quite severe. Growing public concern and a hodgepodge of local and state-level restrictions are starting to crimp consumer spending and hurt economic activity. As the labor market recovery loses momentum, and with a dysfunctional Congress unable to reach a consensus on additional fiscal stimulus, some forecasters are now projecting a potential contraction in GDP in early 2021.

If last ditch efforts to reach a consensus during the lame duck session fail, Yellen will have to hit the ground running and be prepared to table targeted fiscal stimulus measures (aimed at replacing lost income and aiding local and state governments facing severe budgetary shortfalls) for congressional approval as soon as the Biden administration takes office. Chairman Powell is expected to work closely with Yellen to make a strong public push for fresh fiscal stimulus. Expectations of fresh fiscal stimulus and continuation of monetary policy accommodation, along with positive developments on the vaccine front, have recently pushed U.S. equities to record levels.

In fact, there is not only widespread acknowledgement of the need for short-term fiscal stimulus to overcome an expected winter slowdown, but there now appears to be a growing consensus within U.S. policymaking circles that running the economy hot in 2021-22 may provide significant upside benefit in the form of substantial employment gains (especially among economically marginalized groups) with only limited downside risk as inflationary pressures remain largely muted.

There are, however, at least three major long-term economic issues that are likely to pose significant policy challenges for the Yellen-Powell duo. First and foremost, the K-shaped economic recovery from the initial pandemic shock has further exacerbated income and wealth inequality in the U.S. and unleashed forces that are likely to widen the gap between economic winners and losers. A more rapid digitalization of the U.S. economy will reinforce the skill-biased technological trends that had already contributed to a large economic gap between high-skilled workers (and capital owners) and low- and mid-skilled workers.

Second, while the CARES Act and other fiscal stimulus programs aided the U.S. economy dealing with the initial pandemic shock, the resultant growth in U.S. public debt poses a long-term risk. Once the economic recovery is well underway, the Yellen-Powell duo will have to consider potentially unpopular measures (such as higher taxes, spending cuts and partial monetization of public debt) to stabilize U.S. government debt-to-GDP ratio.

Furthermore, while there is a tremendous need for government spending on infrastructure, public research and development, and worker retraining and skill-upgrading programs, the growing expenditure on transfer programs (Social Security, Medicare and Medicaid), and on military and interest payments is projected to swallow up much of the outlays in the coming decades. Reorienting public spending priorities, while clearly necessary, is likely to be politically difficult.

Third, excessive reliance on ultra-loose monetary policy over the past few decades created financial distortions that have resulted in asset price bubbles and debt-fueled boom-bust cycles. Even during the pandemic, the astonishingly rapid recovery in equity markets was at least partly driven by the wave of liquidity unleashed by the Federal Reserve. Meanwhile, record low mortgage rates have fueled a dramatic boom in single-family homes. Surge in asset prices widens wealth inequality and often benefits older segments of the population at the expense of the younger generations. In an era of persistently low interest rates, the Yellen-Powell duo may need to place a greater emphasis on financial stability and work on developing effective macro-prudential tools.

Clearly, the expertise of a seasoned economist such as Janet Yellen is what the country needs right now, and she is likely to quickly restore both domestic and international confidence in the U.S. Treasury. There is also clarity regarding the short-term macroeconomic policy actions necessary to aid the U.S. economy (additional and well-targeted fiscal stimulus and greater monetary and fiscal policy coordination). Longer-term, however, the challenges posed by widening income and wealth inequality, record levels of public debt and financial distortions are likely to pose much tougher challenges for the Yellen-Powell team.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.