What’s Needed in the Next Fed Chief

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr.

Here’s what we now know: the president will soon nominate a replacement for Ben Bernanke to lead the Federal Reserve and it won’t be the former front-runner, Lawrence H. Summers, who withdrew his name from consideration in the face of opposition from members of the Senate Banking Committee. That should make the Fed vice chairwoman, Janet Yellen, the new front-runner â€" but rather than get wound up about the next horse race, I’d like to skip ahead to the confirmation hearing and talk about what characteristics I think would be most important in the next Fed chief.

To be clear, I fear little of this will come up in a substantive way during the candidate’s confirmation.  Those tend to be anodyne affairs where the person in the hot seat tries to stay cool while not saying anything that could prove damaging, often in the face of grandstanding on senators’ pet issues.  (“How do you feel about apple pie?”  “I judge apple pie to be a fine example from the pie genus, but I would add that other fruit pies might also fit well into that categorization.”)

Still, the rest of us should take advantage of this moment to think about the most important attributes for the Fed’s next leader.

Bubble watcher: Neither Mr. Bernanke nor his predecessor, Alan Greenspan, believed that the Federal Reserve could identify asset price bubbles or do much about them, especially with interest rates (“a blunt tool” for that purpose, as Mr. Bernanke said).  Yet in both of their cases, we know that they were warned of the housing bubble by (a precious few) colleagues.  The economist Dean Baker was showing me graphs of home prices diverging from rental prices in a novel and scary pattern back in 2002!

Add that to the “shampoo economy” we’ve been stuck with for the last three business cycles (“bubble, bust, repeat”) and the protracted damage that has resulted, and I suspect you’ll agree that we can’t afford to have the next Fed chief shun the role of identifying bubbles.

And while Mr. Bernanke is right that interest rates are a blunt tool â€" raising them to pop the bubble could also pop the expansion â€" that’s not the only anti-bubble tool, which brings me to:

Bank regulator: Here’s something I learned during my stint at the White House during the financial crisis.  To bail out banks invokes deep moral hazard, which makes such moves both deservedly unpopular and bad economics (“moral hazard” exists when an economic actor or institution doesn’t face the cost of its actions, like when you bail out a bank that screwed up).  But given the global interconnectedness of financial institutions â€" and connectedness, not size, is the relevant and threatening factor here â€" the Fed (and Congress) could easily be back in the bailout business unless proactive steps are taken.

In other words, avoiding moral hazard is a luxury you often don’t have once the implosion has begun.  So your best move is to avoid it.

That’s what the Dodd-Frank financial reform was all about, right?  Well, yeah, but as Alan Blinder argues, the long delay in putting it into effect has given opponents time to whittle away at it: “Sadly, even this good-though-weak law now seems to be withering on the regulatory vine. Far from being tamed, the financial beast has gotten its mojo back â€" and is winning. The people have forgotten â€" and are losing.”

Mr. Greenspan’s ideology allowed him to convince himself that financial markets are self-regulating, despite the fact that economists since Adam (Smith) have known this to be wrong.  As with the bubbles, the next Fed chief can’t kick back and wait for the problems to surface.

Consumer ally: The next Fed chief must learn to love and work closely with the Consumer Financial Protection Bureau.  I’d recommend a standing lunch date with Richard Cordray, the agency’s first director and someone with sharp antennae for credit irregularities that can serve as early warnings for bubbles.

Macro-manager: This is huge, of course, and the challenges here are well known.  Mr. Bernanke, aided by Ms. Yellen, has been consistently strong in using both traditional interest rate policy and creative asset purchasing and forward guidance methods in the pursuit of closing persistent output gaps.

And while the current period is unusually slack, the fact is that for most of the last 30 years unemployment has been above the full-employment level, and inflation, in turn, has been relatively quiescent.  I’m not making any claims about some grand moderation in price pressures â€" such sweeping proclamations somehow seem to set off events that prove them horribly wrong.  But I do think an objective look at the data should lead the next Fed chief to be very careful to give adequate weight to the full-employment side of the central bank’s dual mandate (i.e., maximum employment consistent with stable prices).

More often than not, accelerating inflation has been a phantom menace, while high unemployment with all the problems it causes, from wage stagnation to higher inequality, has been the real monster.

Better forecaster: Related to the problem of missing bubbles, the Fed has been a systematically optimistic forecaster, which sounds a lot more benign than it is.  It has consistently had to mark down its estimates, and that kind of premature green-shoot spotting could be one reason Fed officials are talking about tapering (pulling back a bit on their asset purchase program) too soon.

The next Fed chief needs to recalibrate the model.  I’ve got two suggestions: build financial markets into the model, with a particular emphasis on leverage, and (deep wonkery alert) take a look at “dynamic factor modeling.” I’ve been fooling around with this method (and talking to some actual experts) and think it might be a marked improvement over standard macro models (it’s a way to distill a lot more information than is typically used into common factors underlying the way economic variables affect each other).

Communicator: I put this in here for the sake of completeness, but it may matter less than you’d think.  Especially compared to Mr. Greenspan, Mr. Bernanke has been quite a clear communicator of the Fed’s actions, yet the institution is probably viewed with greater suspicion now.

I suspect that if the new chief helps improve the Fed’s performance in all the areas I’ve noted, allowing us to get out of the shampoo cycle and seriously lower the jobless rate, he or she could go on TV babbling about dynamic factor models and we’ll all love it.