Yellen Dissected

February 14th, 2017 11:27 am | by John Jansen |

Via Stephen Stanley at Amherst Pierpont Securities:

Chair Yellen’s prepared testimony is in my view easily the most hawkish message that she has ever delivered in her tenure as Fed Chair.  She stopped short of promising a rate hike in March, but she did more than enough to put March on the table, and, perhaps more importantly, she sent a clear signal that the Fed is likely to raise rates multiple times this year.

I’m going to hit the monetary policy section first and the economic description last, reversing the order of the actual speech.

Monetary Policy

There are three huge signals in here, which I will take in order of importance, not by the order that they appear in the speech:

1)      The Bar for Future Hikes Is Low.  “Incoming data suggest that labor market conditions continue to strengthen and inflation is moving up to 2 percent, consistent with the Committee’s expectations. At our upcoming meetings, the Committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”  There are two pieces here.  One, the economy is doing everything needed to meet the Fed’s economic projections.  Two, if the economy continues to “evolve in line with these expectations,” then “a further adjustment” would “likely be appropriate” “at our upcoming meetings.”  This turns on its head the default stance of Yellen and the doves for the last several years.  Typically, the doves have always argued that they needed to see just a little more.  Whatever progress was being made was never quite enough.  Doves could always point to a weak jobs number, wage reading, core inflation result, or whatever to delay a move for six more weeks.  After all, what harm could be done in six weeks.  What she said today is that the economy currently justifies further rate hikes unless something changes.  I view that as a low bar to rate moves.  And note that she uses the phrase “at our upcoming meetings,” which very clearly puts a March rate move on the table.

2)      Backing Off of the Low Neutral Rate Argument.  A staple of speeches by Yellen and other doves in recent years has been the argument that the neutral funds rate was extraordinarily low, which meant that the current policy stance was a little accommodative, but not by that much.  However, Yellen’s tone on this construct today is much different.  She notes that the FOMC believes that the neutral rate will “rise somewhat over time” as various headwinds diminish.  The concepts are not totally new, but the emphasis is quite different, providing another reason why the Fed is likely to need to raise rates, and more than once or twice.

3)      Highlighting Upside Risks.  For years, Chair Yellen and other doves on the Committee have always found downside risks around every corner and under every rock.  No matter how good the U.S. economic data looked, there were always downside risks from the global economy or other bogeymen.  However, today, Chair Yellen only specifically discusses one risk scenario: “As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”  To be fair, as she notes, she has made this point before.  However, it was usually balanced by various downside risks.  In this case, there is no such balance.  And the “waiting too long” risk is not placed as an add-on at the end of an extended discussion of the policy outlook.  It is basically the leading idea that she lays out.  This is a case where context matters, and the fact that she led with this idea is important, especially for the question of whether the Fed may go in March.

There were two other points related to monetary policy.  On the interaction with fiscal policy, Yellen simply notes that it is too early to know what may be coming, and the FOMC will set its policy as it always does, to attain maximum employment and price stability, and fiscal policy is merely one of a myriad of inputs to that equation.  Second, Yellen had nothing more than boilerplate on the balance sheet, noting that the Fed continues to reinvest, which is part of its effort to maintain accommodative financial conditions (more on this below, reflecting Q&A commentary).

Economic Outlook

Yellen’s assessment of the economy is straightforward.  The labor market has improved significantly since her last semi-annual testimony in mid-2016.  She does not take a position on whether the economy is at, near, or past full employment.  She walks through the various components of GDP.  Consumers have been strong, and business spending was soft last year.  Inflation has been creeping higher.  Market-based inflation expectations remain low but have risen, providing some comfort to the Fed.  She notes that the FOMC expects the economy to “continue to expand at a moderate pace, with the job market strengthening somewhat further and inflation gradually rising to 2 percent.”  She adds that the Committee expects the pace of global economic activity “should pick up over time.”

Q&A on the Balance Sheet

Right off the bat, Chair Yellen was asked about the balance sheet, and she gave a lengthy prepared answer (clearly, the Fed knew this question would come).  She explained that the Fed wants to get the balance sheet down to a sharply lower level but will only do so when the FOMC is comfortable that the economy is strong enough to handle it and that the funds rate is far enough away from zero that the Fed has room to ease if things were to go south.  She explained that the FOMC does not intend to actively manage the balance sheet as a monetary policy tool.  Instead, the Fed will attempt to shrink the balance sheet with as little disruption to the markets as possible.  This means using passive roll-off to get the balance sheet down in size, and she repeated the Fed’s view that it will not ever sell MBS directly into the market.  She did not convey a sense of urgency about starting this process, but noted that the Committee will be discussing how and when to begin paring the size of the balance sheet at future meetings.  The most interesting aspect of her response in my view was the idea that the Fed does not intend to use management of the size of the balance sheet as a component of monetary policy.  There had been some talk from one or two Fed officials that a more aggressive shrinkage of the balance sheet could serve as a substitute for rate hikes at some point down the line.  This does not appear to be the way that the FOMC is thinking about the balance sheet.  I would also note that her comments suggest to me that, all else equal, the longer the Fed waits to start paring the balance sheet, the quicker it may scale in roll-off.  One can envision a scenario where the Fed starts soon but then takes the better part of a year to “reverse taper” roll-off.  My guess is if the Fed waits a while, as I expect, then this “taper” process may take place over a much shorter time period than the tapering of the last round of QE did.

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