February 24th, 2015 1:35 pm
Via Stephen Stanley at Amherst Pierpont Securities:
On the economy, Yellen’s testimony repeated the general thrust of the January FOMC minutes. With regards to the two parts of the dual mandate, the verdict is mixed. Yellen noted that the employment situation “has been improving along many dimensions.” She concludes with “considerable progress has been achieved in the recovery of the labor market, though room for further improvement remains.” In terms of GDP and spending, she notes that the economy has been “increasing at a solid rate.” She expects continued above trend growth going forward, though she acknowledges that housing remains sluggish and the economy has not yet reached potential.
She acknowledges the fall in long-term bond yields globally but is not particularly concerned, attributing the declines to “disappointing foreign growth and changes in monetary policy abroad.” She discusses the fall in oil prices as well, noting that “it will likely be a significant overall plus, on net, for our economy.”
She weighs in on the downside risks to the U.S. economy posed by foreign economic developments. Her tone is not as negative as that of the FOMC minutes from a few meetings ago, as she points out that “the pace of growth abroad appears to have stepped up slightly.” She also notes that stimulus from foreign central banks and the drop in oil prices could boost growth more than expected.
On inflation, she highlights the fall in headline inflation due to the decline in energy costs. She notes that core inflation has also slowed, “in part reflecting declines in the prices of many imported items and perhaps also some pass-through of lower energy costs into core consumer prices.” She asserts that inflation expectations are stable, blaming the fall in inflation compensation on other factors. Her bottom line is that “the Committee expects inflation to decline further in the near term before rising gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate, but we will continue to monitor inflation developments closely.”
As I predicted in my summary, Yellen leaves the impression that the timing of liftoff will mainly be determined by the inflation outlook. The Fed has seen enough on the growth and labor market fronts, but wants to see core inflation level off after the deceleration seen in recent months. As an aside, I think it is worth noting that there is no mention of wages anywhere in the inflation discussion. Market participants have put too high of a weight on wages in the inflation debate, and the Fed has not validated that view, even a Phillips Curve devotee like Yellen. Wages are a proxy (one of many) for measuring labor market slack, and, as noted above, I think the Fed has pretty much seen enough on that front, so while market participants may choose to continue to overreact to developments in wages, Yellen certainly did not justify such a response (having said that, you all know that I expect wages to perk up significantly this year, and the news headlines in recent days and weeks are finally beginning to bear that out).
On monetary policy, Yellen explains why the Fed holds its current stance, including the use of the “patient” forward guidance language. She repeats that “patient” means no move for “at least the next couple of FOMC meetings.” She then tells us how things will go moving forward: “If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance.” So, the FOMC will take “patient” out when it believes that things have progressed to a point that it can begin to consider a rate hike on a meeting-to-meeting basis.
Once it takes that step, there is no predetermined timetable. “However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee’s judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.”
She then synthesizes the checklist introduced in the January FOMC minutes for what is required to justify liftoff. Basically, it’s only a little firming in inflation. “Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.”
She concludes by repeating the “lower for longer” thought that policy will probably remain accommodative even well after the Fed is meeting its dual mandate objectives.
On policy normalization, she walks through the mechanics of how rate hikes will work. The Fed will be focused on moving rates higher rather than “by actively managing the Federal Reserve’s balance sheet.” This means no asset sales any time soon. On rates, the Fed will use the IOER rate as its primary tool, with the overnight RRP facility and other tools as supplements to defend their target range for short rates. The supplementary tools will be phased out when they are no longer needed, so the RRP structure, term deposit facility, etc. are all merely with us until the balance sheet returns to normal. Finally, in terms of managing the size of the balance sheet down, “the Committee intends to reduce its securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal from securities held by the Federal Reserve.” Eventually, the FOMC has no intention of maintaining a large balance sheet permanently and it wants to return to a Treasuries-only stance: “it is the Committee’s intention to hold, in the longer run, no more securities than necessary for the efficient and effective implementation of monetary policy, and that these securities be primarily Treasury securities.”
For me, the bottom line is that Chair Yellen sets the stage for taking “patient” out soon. It does not have to be in March, but I think it will be. At that point, a rate hike becomes a live option beginning in June. Whether they move or not in June will depend mostly on how the inflation outlook evolves by then. I look for sufficient firming to justify a move in June. Others will no doubt disagree, but the data will be the final arbiter.
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