I came back from Spring Break vacation to find a detailed speech by Fed Chair Janet Yellen that further lays the groundwork for rate hikes to begin later this year. The speech is a remarkably clear elucidation of her views and provides plenty of insight into what we should be looking for as the Fed edges toward policy normalization. A speech like this once a month from a Federal Reserve Governor would, I think, go a long way toward enhancing the Fed's communication strategy.
One of the most important takeaways from this speech is the importance of labor market data in the Fed's assessment of the appropriate level of accommodation:
Although the recovery of the labor market from the deep recession following the financial crisis was frustratingly slow for quite a long time, progress has been more rapid of late...Of course, we still have some way to go to reach our maximum employment goal...But I think we can all agree that the recovery in the labor market has been substantial.
I am cautiously optimistic that, in the context of moderate growth in aggregate output and spending, labor market conditions are likely to improve further in coming months. In particular, and despite the somewhat disappointing tone of the recent retail sales data, I think consumer spending is likely to expand at a good clip this year given such robust fundamentals as strong employment gains, boosts to real incomes from lower energy prices, continued increases in household wealth, and a relatively high level of consumer confidence.
Yellen intends to look through any first quarter weakness in GDP data, seeing it as largely an aberration (like arguably the first quarter of last year), as long as the employment data continues to hold up. And even there, I doubt any one weak report would do much to undermine her confidence in the recovery; we should be focusing on the story told by the next three employment reports in aggregate.
Regarding inflation, she sees little that worries her:
...Some of the weakness in inflation likely reflects continuing slack in labor and product markets. However, much of this weakness stems from the sharp decline in the price of oil and other one-time factors that, in the FOMC's judgment, are likely to have only a transitory negative effect on inflation, provided that inflation expectations remain well anchored.
In this regard, I take comfort from the continued stability of survey measures of longer-run inflation expectations. And although market-based measures of inflation compensation have declined appreciably since last summer and bear close watching, I suspect that these declines are primarily driven by changes in risk premiums and market factors that I expect to prove transitory...
Same story - as long as the employment data is solid, they will dismiss the inflation data. Regarding expectations for the first rate hike, she makes clear that a hike later this year is not likely just in the FOMC's opinion, but in hers as well:
Like most of my FOMC colleagues, I believe that the appropriate time has not yet arrived, but I expect that conditions may warrant an increase in the federal funds rate target sometime this year.
A beginning for her story is the implications of zero rates:
I would first note that the current stance of monetary policy is clearly providing considerable economic stimulus. The near-zero setting for the federal funds rate has facilitated a sizable reduction in labor market slack over the past two years and appears to be consistent with further substantial gains. A modest increase in the federal funds rate would be highly unlikely to halt this progress, although such an increase might slow its pace somewhat.
Note again that Yellen highlights the importance of labor market gains in assessing the stance of policy. Then she pulls out the long-lags story:
Second, we need to keep in mind the well-established fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.
Yellen simply believes that if the Fed waits until inflation is back to target before the Fed acts, policy will be behind the curve, thereby raising the risk that policy will need to tighten dramatically at some point in the future. There is also the secondary concern of financial instabilities. Moreover, Yellen has full faith in the Phillips Curve:
An important factor working to increase my confidence in the inflation outlook will be continued improvement in the labor market. A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten.
And that faith thereby negates the value of the current low readings on inflation:
It is largely for this reason that a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.
And then she completely dismisses the importance of wage growth in her assessment of the path of inflation:
With respect to wages, I anticipate that real wage gains for American workers are likely to pick up to a rate more in line with trend labor productivity growth as employment settles in at its maximum sustainable level. We could see nominal wage growth eventually running notably higher than the current roughly 2 percent pace. But the outlook for wages is highly uncertain even if price inflation does move back to 2 percent and labor market conditions continue to improve as projected. For example, we cannot be sure about the future pace of productivity growth; nor can we be sure about other factors, such as global competition, the nature of technological change, and trends in unionization, that may also influence the pace of real wage growth over time. These factors, which are outside of the Federal Reserve's control, likely explain why real wages have failed to keep pace with productivity growth for at least the past 15 years. For such reasons, we can never be sure what growth rate of nominal wages is consistent with stable consumer price inflation, and this uncertainty limits the usefulness of wage trends as an indicator of the Fed's progress in achieving its inflation objective.
An array of nominal wage growth outcomes might be consistent with 2 percent inflation, most of which are outside the purview of the Fed, according to Yellen. Hence:
I have argued that a pickup in neither wage nor price inflation is indispensable for me to achieve reasonable confidence that inflation will move back to 2 percent over time.
But she leaves an out:
That said, I would be uncomfortable raising the federal funds rate if readings on wage growth, core consumer prices, and other indicators of underlying inflation pressures were to weaken, if market-based measures of inflation compensation were to fall appreciably further, or if survey-based measures were to begin to decline noticeably.
She doesn't need to see any of these indicators to head up to justify a rate hike; they just can't head down. In that respect, today's reading on PCE inflation must be something of a comfort to her. The month-over-month number pulled up, although recent trends are in my opinion still weak:
All that said, she still believes that Taylor-type rules - using the correct equilibrium interest rate, of course - still justify a zero interest rate:
But the prescription offered by the Taylor rule changes significantly if one instead assumes, as I do, that appreciable slack still remains in the labor market, and that the economy's equilibrium real federal funds rate—that is, the real rate consistent with the economy achieving maximum employment and price stability over the medium term—is currently quite low by historical standards.Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero.
And this prepares the listener for what I would argue is the most important part of her speech:
The FOMC will, of course, carefully deliberate about when to begin the process of removing policy accommodation. But the significance of this decision should not be overemphasized, because what matters for financial conditions and the broader economy is the entire expected path of short-term interest rates and not the precise timing of the first rate increase
The Fed very much wants to change the discussion from the timing of the first rate hike to the pace of subsequent rate hikes. On this topic, we need to delve further into the importance of the equilibrium real rate in assessing the path of policy:
The projected combination of a gradual rise in the nominal federal funds rate coupled with further progress on both legs of the dual mandate is consistent with an implicit assessment by the Committee that the equilibrium real federal funds rate—one measure of the economy's underlying strength—is rising only slowly over time. In the wake of the financial crisis, the equilibrium real rate apparently fell well below zero because of numerous persistent headwinds. These headwinds include tighter underwriting standards and restricted access to some forms of credit; the need for households to reduce their debt burdens; contractionary fiscal policy at all levels of government after the initial effects of the fiscal stimulus package had passed; and elevated uncertainty about the economic outlook that made firms hesitant to invest and hire, and households reluctant to buy houses, cars, and other discretionary goods.
So what is happening with the real equilibrium rate now:
Fortunately, the overall force of these headwinds appears to have diminished considerably over the past year or so, allowing employment to accelerate appreciably even as the level of the federal funds rate and the volume of our asset holdings remained nearly unchanged.
Employment is again the key indicator. The fact that employment growth is accelerating despite no change in monetary policy is, according to Yellen, fairly clear evidence that the equilibrium real rate is rising. In other words, monetary policy accommodation is actually increasing even as the Fed holds steady. She expects the equilibrium rate to continue rising over the next couple of years, thereby justifying the Fed's rate projections.
But that forecast is data dependent, of course. And then comes the portion of Yellen's speech as she highlights reasons to believe that the actual rate path may differ from the Fed's expectations. Note, that primarily focuses on reasons to expect a more subdued rate path, thus sounding dovish. She begins with the uncertainty of the equilibrium real rate:
The first, which is closely related to my expectation that the headwinds holding back growth are likely to continue to abate gradually, pertains to the risk that the equilibrium real federal funds rate may not, in fact, recover as much or as quickly as I anticipate...The experience of Japan over the past 20 years, and Sweden more recently, demonstrates that a tightening of policy when the equilibrium real rate remains low can result in appreciable economic costs, delaying the attainment of a central bank's price stability objective.
The fact that she highlights the errors of the Riksbank is comforting; it speaks to the willingness to learn from others' mistakes. Next is a tacit admission that although they say they can return to quantitative easing, they really think they are pretty much out of bullets:
A second reason for the Committee to proceed cautiously in removing policy accommodation relates to asymmetries in the effectiveness of monetary policy in the vicinity of the zero lower bound. In the event that growth in employment and overall activity proves unexpectedly robust and inflation moves significantly above our 2 percent objective, the FOMC can and will raise interest rates as needed to rein in inflation. But if growth was to falter and inflation was to fall yet further, the effective lower bound on nominal interest rates could limit the Committee's ability to provide the needed degree of accommodation. With an already large balance sheet, for example, the FOMC might be concerned about potential costs and risks associated with further asset purchases.
On this point, it is again comforting that she is not ignoring the signals of the bond market:
That said, it is sobering to note that many market participants appear to assess the risks to the outlook quite differently. For example, respondents to the Survey of Primary Dealers in late January thought there was a 20 percent probability that, after liftoff, the funds rate would fall back to zero sometime at or before late 2017. In addition, both the remarkably low level of long-term government bond yields in advanced economies and the low prevailing level of inflation compensation suggest that financial market participants may hold more pessimistic views than FOMC participants concerning the risks to the global outlook. Since long-term yields reflect the market's probability-weighted average of all possible short-term interest rate paths, along with compensating term and risk premiums, the generally low level of yields in advanced economies suggests that investors place considerable odds on adverse scenarios that would necessitate a lower and flatter trajectory of the federal funds than envisioned in participants' modal SEP projections.
Finally, she harkens back to her optimal-control policy days:
A final argument for gradually adjusting policy relates to the desirability of achieving a prompt return of inflation to the FOMC's 2 percent goal, an objective that would be advanced by allowing the unemployment rate to decline for a time somewhat below estimates of its longer-run sustainable level. To a limited degree, such an outcome is envisioned in many participants' most recent SEP projections.
Still, the gradualist path is not without risks. First, inflation:
Of course, taking a gradualist approach is not without risks. Proceeding too slowly to tighten policy could have adverse consequences for the attainment of the Committee's inflation objective over time, especially if it were to undermine the FOMC's inflation credibility. Inflation could, for example, exhibit nonlinear dynamics in which high levels of unemployment place relatively little downward pressure on inflation, but tight labor markets generate marked upward pressure. If so, a decline in unemployment below its natural rate could cause inflation to quickly rise to an undesirably high level. Rapid increases in short-term interest rates to arrest such an unwelcome development could, in turn, have adverse effects on financial markets and the broader economy.
Here you see Yellen's fear of inflation, in particular the concern of nonlinear dynamics. Yellen fears that inflation will jump sharply higher if unemployment sinks too far below its natural rate. This fear I think extends to the Fed's resistance to a different inflation target or a price level target. It is also why the Fed fears falling too far behind the curve.
Bottom Line: Employment data are key; the rest is for the moment just noise. If that data continues to improve, while monetary policy remains unchanged, it is evidence of growing monetary accommodation which must eventually be constrained. Moreover, the steady fall in the unemployment rate is signaling above trend growth as well. And while you might argue that employment data are a lagging indicator, the Fed would reply that there is no indication from the more leading indicator of initial claims that something troubling is amiss. Somewhat surprisingly, even price data is currently just noise; rising inflation or wage growth are not necessary to begin raising rates. Still, either would justify the acceleration of subsequent rate hikes as they would be evidence of a more normal economy consistent with a higher equilibrium real interest rate. Yellen anticipates that the equilibrium rate will return to more normal levels over the next couple of years, but remains wary that this will not turn out to be the case. This is good news as it raises the odds that she will not cut the expansion short. Her lack of emphasis of wages as a policy signal and continued faith in the Phillips Curve will make her a target of left-leaning critics.
