Thursday, March 20, 2014

Fed Vice Chair Janet Yellen, who has been the Fairy Godmother of the Bull Market, didn’t sprinkle any fairy dust on the bond and stock markets yesterday. Bond and stock prices fell following the release of the FOMC statement at 2:00 pm. There weren’t any real surprises in the statement. Rather, traders seemed to be disturbed by the quarterly economic projections of the FOMC participants that were released with the statement. Their consensus outlook for the economy didn’t change much from their December projections. However, there was a slight increase in the median forecast for the federal funds rate at the end of 2015. Bloomberg reported the story as follows:
Federal Reserve officials predicted their target interest rate will be 1 percent at the end of 2015 and 2.25 percent a year later, higher than previously forecast, as they upgraded projections for gains in the labor market. Most Federal Open Market Committee participants reiterated their view that the Fed will refrain from raising the benchmark interest rate until 2015. The median rate among 16 Fed officials rose from December, when they estimated the rate at the end of next year at 0.75 percent, and 1.75 percent for the end of 2016. … A majority of FOMC participants--13 out of 16--expect the first increase in the main interest rate in 2015. One projected the first rate increase in 2014, while two forecast an initial move in 2016.
The participants’ federal funds forecasts are shown as a “dot plot” in the Fed’s projections document. In her press conference at 2:30 p.m., Yellen basically said to ignore the dot plot and focus on the statement. Then she exacerbated the sell-off when she was asked how long it might be before the Fed started raising rates.

The statement implied that the Fed would continue tapering QE, and was on course to terminate the program by the end of this year or early next year as long as the economy performed well. As for when interest rates might start rising, the statement said:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
When she was asked to define “considerable time” in the press conference, Yellen said six months, triggering further declines in stock prices. I bet she regrets having been that specific, especially given that the statement junked the specific 6.5% unemployment rate threshold for the FOMC to start talking about raising interest rates. Instead, this threshold was replaced with a fuzzier set of guidelines with a “wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

So the FOMC seems to have dropped its “data dependent” approach specifying a threshold for a specific economic indicator and replaced it with a much more discretionary qualitative approach. Yellen’s comment suggests a slight reversion to the “calendar based” approach that had been the FOMC’s modus operandi until December 2012, when the jobless rate threshold was adopted.

In my opinion, Yellen confused herself and all of us too. My hunch is that she meant that the federal funds rate would be raised six months after the economy achieved the Fed’s mandates for inflation and unemployment. We know that the former is 2%. The latter is probably 5.2%-5.6% based on the projections crib sheet, which shows that this forecast isn't expected to be achieved until 2016! Here is how the statement framed it:
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
I interpret this sentence to mean that the Fed won’t start raising rates until after the mandates are achieved. I will concede that might be six months after QE is terminated, but who knows? All in all, my evaluation is that Janet Yellen’s first shot at communicating Yellenomics rates a grade of D.

Of course, Yellen talked about lots of other subjects. She confirmed that her “dashboard” of key economic indicators includes the U-3 and U-6 unemployment rates. She is also watching the number of discouraged workers and the ones who are marginally employed, as well as the share of the long-term unemployed. She sees progress in the labor market, but she also sees too much distress. She also mentioned the labor force participation rate, which may be falling for demographic reasons, but still has a cyclical component, in her opinion. She is also watching quit rates, job openings, and the hiring rate, which is still too low, in her opinion.

Yellen said that wage inflation should be running around 3%-4% given the increase in productivity. She noted that other than a small spike in one measure, wage inflation remains around 2%. No one asked her about financial bubbles or about emerging economies.
(Based on an excerpt from YRI Morning Briefing)

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