Yellen: Shades of Grey

Fed Chair Janet Yellen and I have something in common. We both studied under Professor James Tobin, a Nobel laureate, in the graduate economics department at Yale University. She graduated with a PhD degree six years before I did. I actually studied from a Xerox copy of the neat and meticulous notes she took in Tobin’s course on macroeconomics. They were called the “Yellen notes.” We also both have grey hair, though I have more shades of grey.

Today and tomorrow, Yellen will testify before two congressional committees on monetary policy. It will be interesting to see how she shades the outlook for Fed policy. The minutes of the January 27-28 FOMC meeting, released last Wednesday, was widely perceived to be dovish, suggesting that the committee’s members are in no rush to raise interest rates. They remained “patient.” However, on February 6, January’s employment report was so strong that everyone concluded that the Fed will commence “lift-off” at the June 16-17 meeting of the FOMC.

That means that the FOMC will have to decide whether to drop the “patient” clause in either the March 18 or April 29 statement to prepare the markets for a rate hike on June 17. The latest minutes noted:

Many participants regarded dropping the ‘patient’ language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.

My hunch is that Yellen will suggest that labor market conditions have improved sufficiently so that the FOMC can proceed with the first rate hike at mid-year. However, she is likely to also say that the Fed will remain patient about further rate hikes, increasing the likelihood of “one-and-done” for this year. Here is a possible scenario for the evolution of the “patient” clause in the FOMC statements:

(1) Dec.17 actual:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October …

(This was the first time that the word “patient” appeared in the statement.)

(2) Jan. 28 actual:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.

(This was the first time that the “considerable time” phrase was deleted from the statement since it first appeared in this context on September 13, 2012.)

(3) Apr. 29 hypothetical:

Based on its current assessment, the Committee judges that it can be patient in normalizing the stance of monetary policy once it begins.

(In other words, rate hikes will begin soon, but will proceed at a patient pace. That would be similar to, but more gradual than, the “measured pace” of tightening from June 30, 2004 to June 29, 2006.)

If that’s the way things go, then stock prices should continue to move higher. They could even melt up. That’s especially likely if Yellen doesn’t mention any serious concerns about overvaluation in the financial markets as she did during her July 15, 2014 semiannual monetary policy testimony to Congress. Back then, she said in her prepared remarks:

The [FOMC] Committee recognizes that low interest rates may provide incentives for some investors to ‘reach for yield,’ and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance.

The monetary policy report that accompanied her testimony specifically noted:

Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.

Previously, I’ve noted on numerous occasions that Yellen has been the “Fairy Godmother of the Bull Market.” The S&P 500 has tended to rise after she spoke publicly about monetary policy and the economy. Let’s see if she sprinkles more fairy dust today and tomorrow.

By the way, Jon Hilsenrath, the WSJ’s ace Fed watcher, observed last Thursday that the latest minutes weren’t as dovish as widely believed:

The central bank held a special ‘policy planning’ session to discuss the appropriate timing of interest rate increases. Officials had a long and detailed briefing from staff on the tools it would use once it started raising interest rates. In addition the staff briefed officials on the alternate interest rate paths it might choose for a series of interest rate increases, with historical and international comparisons. Moreover officials discussed removing the assurance from its policy statement that it will be patient before raising rates. Fed Chairwoman Janet Yellen is a methodical planner known since her childhood for doing her homework. Her Fed has clearly entered an intensive planning stage for interest rate increases.

(Based on an excerpt from YRI Morning Briefing)