Via Stephen Stanley at Amherst Pierpont Securities:
If anyone out there thought that Janet Yellen is anything other than radically dovish, today’s 19-page treatise on monetary policy should close the books on those misconceptions. She laid out a detailed explanation of her thinking that serves in my view as an explanation/defense for the sharp lowering of the FOMC “dots” revealed last week. At every turn, when given a chance, she takes the dovish argument. The only mitigating factor in her speech is that monetary policy has gone from a phase where the FOMC does what it thinks is right regardless of the data to one in which policy has become more data dependent. Thus, her arguments are much more of a conditional forecast than would have been the case before. She acknowledges in many places that the timing and pace of rate hikes will be very much data dependent, so if her arguments that the economy will continue to exhibit slack and low inflation prove wrong, then so will her policy prescriptions. That is different than where we were up until recently, so the focus is slightly less on Yellen’s pronouncements and more on the data than would have been the case a year ago.
Having said that, her view of the world obviously holds considerable weight on how the data are interpreted, so we should care what she thinks.
· On the economy, she remains convinced that despite rapid progress in recent months, there is considerable slack in labor markets. She leans toward an equilibrium unemployment rate of 5.0%, the low end of the FOMC central tendency range, so there is still half a point to go on the traditional unemployment rate. In addition, she points to high levels of involuntary part-time employment and low levels of labor force participation. I have argued that these are both to varying degrees structural (not that there is no cyclical component, but that it is less than Yellen thinks). In the end, the proof is in the pudding. When wages begin to accelerate, we will all know that labor markets are getting tight. I see that sooner, she obviously believes later.
· She downplays the strength in activity by noting that it has only come because the Fed has run an extraordinarily easy policy. I think this reflects a common conceit of the Fed’s that the level of their policy rate is always and everywhere the key fundamental driving the economy. I believe that the level of short rates, within a range from here up to some more reasonable level, say 2%, are far down the list of drivers of real activity. Financial engineering? Absolutely. But business decision makers have not and are not going to alter their plans based on the difference between crazy easy and ridiculously easy monetary policy.
· On inflation, she is concerned about the low level of inflation, but continues to believe that things will begin to move in the right direction soon. This is why she notes that “I expect that conditions may warrant an increase in the federal funds rate target sometime this year.”
· She goes into some detail on what she wants to see to have “reasonable confidence” on the inflation outlook. It is not necessarily a pickup in wages or prices (because if the Fed waits for the whites of the eyes, it will be too late). The first thing she wants to see is further progress in labor markets. While she does not have to see wages and/or price inflation accelerate to move, obviously, a sooner-than-projected pickup in either or both as well as in inflation expectations will get her motivated earlier (and vice versa). This is my favored forecast scenario.
· Turning to the longer-run landscape, she argues that the equilibrium real interest rate for the economy is quite low, perhaps close to zero. This metric, which of course cannot be directly measured, should gradually rise over time, but headwinds continue to hold it below “normal.” This is her argument for why the trajectory of rate hikes over the next few years can be so gradual. Obviously, I am more skeptical of that line of thinking.
· As the speech winds down, she lists three risks to her outlook. The first two are secular stagnation and the zero bound, two reasons for the Fed to liftoff later and stay low for longer. Part of her argument in defense of both risks is the low level of long-term interest rates, which she claims represents a statement by market participants that the outlook is gloomier than the Fed itself thinks. This is in my view another common fallacy held by dovish Fed officials, especially policy activists. The Fed has immensely distorted the financial markets via QE (Stanley Fischer recently asserted based on academic research that QE has lowered long-term interest rates by over 100 BPs). Chair, you can’t have it both ways. If QE worked, then long-term rates are not an accurate gauge of market participants’ long-run economic views. The supply-demand balance was broken by QE3. The level of long-run rates is telling us no more, no less than that.
· She does provide some window dressing in the other direction at the end of her speech, acknowledging that there are risks of the Fed staying too low for too long. However, this is clearly secondary in her mind to the risks of going too soon and/or too aggressively.
So, my main takeaway from her speech is that she will view the data with an open mind but that she begins the data-dependent era viewing the numbers through a very dovish prism.