The White House says that San Francisco Fed president Janet Yellen is President Obama’s leading candidate for vice chairman of the Fed—the number two spot after Fed Chairman Bernanke. The open position comes by way of the retiring Fed governor Donald Kohn, who plans to step down in June. Meantime, Yellen says she’ll accept if nominated.

It’s also clear that Yellen’s in no rush to raise interest rates. The key reason is the weak labor market. As she explained in a speech earlier in the week,

I’m happy to see evidence that the job market is turning around. The pace of job losses has slowed dramatically. Had it not been for blizzards back East, we might have seen payrolls expand in February. Temporary jobs are growing, and that’s usually a signal that permanent hiring is poised to rebound. I was heartened when the unemployment rate dropped in January to 9.7 percent from 10 percent the month before. I was further encouraged when the rate remained at 9.7 percent in February, suggesting it was not just a flash in the pan. In the months ahead, we could get a bump in employment from census hiring. But that, of course, would be temporary. Given my moderate growth forecast, I fear that unemployment will stay high for years. The rate should edge down from its current level to about 9¼ percent by the end of this year and still be about 8 percent by the end of 2011, a very disappointing prospect.

Some central bank observers worry that Yellen will be too soft on future pricing pressure. She’s “dovish” on inflation, says Alan Meltzer, an economics professor at Mellon University and author of a multi-volume history of the Fed, including A History of the Federal Reserve 1970-1986.
Not so, counters Larry Meyer, head of Macroeconomic Advisers and a former Fed governor with a reputation as a hawk on monetary policy. He wrote a book about his tenure—A Term at the Fed: An Insider’s View—and offers some observations about Yellen. Both were Federal Reserve governors on the interest-rate setting Federal Open Market Committee for a time during the late-1990s. In his book, Meyer recalls one discussion on price stability. “In other words, what level of inflation should the FOMC short for—and why?” He continues,

Janet Yellen, who had taught economics at Harvard, the London School of Economics, and most recently at Berkeley, was the first to address this question. She was very much respected by the members of the Committee, the staff, and the Chairman. I soon became her biggest fan on the Committee.

There is no doubt that low inflation is advantageous, Governor Yellen began. But, she argued, there are also significant costs to very low inflation. If there is zero inflation, for instance, then monetary policymakers cannot lower the “real” interest rate below zero. A little inflation, therefore, gives monetary policymakers a greater degree of latitude to stimulate the economy, permitting them to drive real short-term rates into negative territory, if necessary, to stimulate the economy.

Further, she said, a little inflation “greases the wheels” of the labor market. Relative wages across different industries and occupations must be free to change, thereby signaling workers to migrate from one industry or occupation to another.

In recent days, Meyer continues to support Yellen, opining last week that she’s the “best possible choice” for vice-chairman.
Larry Kudlow thinks otherwise. The supply side economist and television talk-show host quips that ” Yellen Is Spellin’ Future Inflation.” In a recent column, he writes,

The president has nominated Janet Yellen to be vice chair of the Federal Reserve. Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of rising prices, she focuses on the unemployment rate, the volume of new jobs being created and the growth of the overall economy. For Yellen, inflation is caused by too many people working and too much economic prosperity.

Meantime, what does Yellen think of the healthcare reform legislation that the President signed into law earlier this week? In particular, is she concerned that it might boost the red ink on the federal government’s balance sheet? No, she explains: “My guess is, without having done a detailed analysis, that it will not have very significant impacts over the next several years.”
Ultimately, it matters not what Yellen thinks, or how Kudlow, Meltzer or Meyer see Yellen’s role in monetary policy going forward. What matters is what the bond market thinks. It’s not yet clear how this opinion will unfold, but the mystery will be solved soon. Stay tuned…