Janet Yellen, in uncharted territory. Photographer: Andrew Harrer/Bloomberg
Janet Yellen, in uncharted territory. Photographer: Andrew Harrer/Bloomberg

Some major questions stand out as Federal Reserve Chair Janet Yellen heads to Capitol Hill this week for her semi-annual testimony to Congress: particularly, when should the Fed start raising interest rates, and are its unconventional stimulus efforts contributing to a financial bubble?

Unfortunately, neither Yellen nor anyone else is in a position to provide decisive answers at this stage.

Watching for Bubbles

With the unemployment rate falling faster than the Fed expected, and with the end of the extraordinary bond-buying program (known as quantitative easing) currently slotted for October, some officials -- including Philadelphia Fed President Charles Plosser, St. Louis Fed President James Bullard and, more surprisingly, San Francisco Fed President John Williams -- have publicly wondered whether the central bank should move more quickly to start raising interest rates. They worry that failing to do so would increase the probability of problems down the road, particularly when it comes to inflation.

Others, including Yellen, note that significant “slack” remains in the job market: A historically low percentage of the population is participating in the labor force, and too many people are working part time for lack of better options. These Fed officials also want to do whatever they can to counter the risk that long-term unemployment will become even more entrenched, eroding the economy's productive capacity and its responsiveness. Given the still-anemic growth in wages, they don’t see inflation as an imminent threat.

A related issue has to do with the impact of all of the Fed's unconventional policies not only on the economy but also on financial markets -- or what former Fed Chair Ben S. Bernanke called the balance of “benefits, costs and risks.” The experimental policies are intended to push up the prices of stocks, bonds and other financial assets to high levels, in the hopes that the resulting optimism among consumers and companies will cause economic fundamentals to catch up.

Some within the Fed think that the risk of bubbles in financial markets has become too great -- that they have gone beyond what the economy will be able to justify. Their concerns extend beyond the high valuations and low volatility of all sorts of assets, including hard-to-trade ones. They also worry about the behavioral changes that come with excessive financial laxity, such as complacent lending with too-lenient conditions, irresponsible bond issuance and the excessive use of borrowed money -- or leverage -- to boost returns.

Again, Yellen is among those who appear less concerned at this stage. While aware of the risk of bubbles, they think that the problems are isolated: Most would be alleviated by a stronger economic recovery, and the rest could be mitigated by so-called macro-prudential policies designed to improve the resilience of the financial system.

Ideally, Yellen could use her congressional testimony to narrow the differences between the two camps. But Fed chairs typically don't employ the occasion to dissipate new ideas that haven’t already been discussed at a high level in the central bank and, more important, there still isn’t enough evidence to make a conclusive analytical case for either side.

As a result, this week’s congressional testimony will probably focus on territory familiar to markets -- not because Fed officials are unwilling to go further, but because they are unable to do so at this time. Successfully navigating these uncharted waters will require both good judgment and quite a bit of luck.

To contact the writer of this article: Mohamed A. El-Erian at M.El-Erian@bloomberg.net.

To contact the editor responsible for this article: Mark Whitehouse at mwhitehouse1@bloomberg.net.