Fed: Deconstructing Yellen

Fed Chair Janet Yellen gave an important speech this past Friday updating her latest thoughts on monetary policy. It was titled, “The New Normal Monetary Policy.” As I’ve noted frequently in the past, stock prices tend to rise on days that Yellen speaks publicly about monetary policy and the economy. Sure enough, the DJIA rose 34 points on Friday. That’s not much, but last week was a tough one for stocks. (In any event, the DJIA soared 1.5% Monday on expectations the PBOC will join the Fed, ECB, BOJ, and BOE in pouring more liquidity into the financial markets.)

In my opinion, the key new insight in Yellen’s speech is how inflation might impact the course of monetary policy. She is obviously pleased with the performance of the labor market overall. However, she and most of her colleagues have recently lowered their estimate of the unemployment rate that is “normal in the longer run” down to 5.0%-5.2% from 5.2%-5.5%. The actual jobless rate fell from 10.0% at its peak to 5.5% during February, very close to the new normal range.

She believes that if this rate falls closer to 5.0%, then wage inflation should rise, which should push price inflation back up closer to the Fed’s 2% target. She is willing to start raising interest rates before this actually happens as long as she is “reasonably confident” that it will happen. I presume that an unemployment rate closer to 5.0% would make her reasonably confident. In other words, Yellen still believes in the Phillips Curve--i.e., the inverse relationship between the unemployment rate and wage (and price) inflation--although it doesn’t seem to be working so far this time.

Nevertheless, Yellen expects that rates will remain below a normal ascending trajectory for some time. As my friend Mike O’Rourke, the chief market strategist at Jones Trading, observes: “The basic take away is that the FOMC policy normalization process will be only a minor transformation from Zero Interest Rate Policy (ZIRP) to Low Interest Rate Policy (LIRP).” Here are some of the most relevant excerpts from her speech:

(1) Falling joblessness should boost inflation, justifying liftoff:

An important factor working to increase my confidence in the inflation outlook will be continued improvement in the labor market. A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not [emphasis hers] be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.

(2) If inflation weakens, liftoff will be postponed:

I have argued that a pickup in neither wage nor price inflation is indispensable for me to achieve reasonable confidence that inflation will move back to 2 percent over time. That said, I would be uncomfortable raising the federal funds rate if readings on wage growth, core consumer prices, and other indicators of underlying inflation pressures were to weaken, if market-based measures of inflation compensation were to fall appreciably further, or if survey-based measures were to begin to decline noticeably.

(3) Anything is possible:

Let me first be clear that the FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the funds rate target range--one that, for example, would involve similarly sized rate increases at every meeting or on some other schedule. Rather, the actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation.

(4) Asymmetries justify cautious approach to liftoff:

International experience therefore counsels caution in removing accommodation until the Committee is more confident that aggregate demand will continue to expand in line with its expectations--a view that is also supported by the research literature. A second reason for the Committee to proceed cautiously in removing policy accommodation relates to asymmetries in the effectiveness of monetary policy in the vicinity of the zero lower bound. In the event that growth in employment and overall activity proves unexpectedly robust and inflation moves significantly above our 2 percent objective, the FOMC can and will raise interest rates as needed to rein in inflation. But if growth was to falter and inflation was to fall yet further, the effective lower bound on nominal interest rates could limit the Committee's ability to provide the needed degree of accommodation. With an already large balance sheet, for example, the FOMC might be concerned about potential costs and risks associated with further asset purchases.

(5) Normalization shouldn’t be postponed for too long if jobless rate continues to fall:

Second, we need to keep in mind the well-established fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.

(6) Normalization is needed to discourage financial bubbles:

In addition, holding rates too low for too long could encourage inappropriate risk-taking by investors, potentially undermining the stability of financial markets. That said, we must be reasonably confident at the time of the first rate increase that inflation will move up over time to our 2 percent objective, and that such an action will not impede continued solid growth in employment and output.

(Based on an excerpt from YRI Morning Briefing)