Update 184 — Yellen Stays the Course;
The Fed in Search of the New Normal
The Fed’s broadly anticipated 25 basis point increase in the Fed funds rate announced this afternoon represents a continuation of its once-a-quarter pace of “normalization policy” implementation. Janet Yellen has adhered to the policy since her installment as Fed Chair in 2014. The Fed defines this policy as raising its rate in small increments three or four times a year.
What’s the takeaway? Did Yellen or the Fed make real news today? We consider the question from the Hill/White House perspective, the labor standpoint, the market view, and the Fed record.
Since the recession, the Fed has taken an unconventional approach to monetary policy. At the depth of the recession, near-zero short-term interest rates proved inadequate to jumpstart the economy. So the Fed started buying massive volumes of Treasury bonds and mortgage-backed securities to drive down borrowing costs.
The economy is now at full employment (despite decreased labor force participation) and close-to-perfect inflation levels. But short-term rates have yet to return to their “normal” level. Consequently, at its meeting in May, the Fed maintained that it would continue on its “normalization path,” without any uncertainty about the trajectory for steady economic growth.
Despite recent reports of wage stagnation and potential deflation, Janet Yellen said today, “our current system is working well.” She said inflation rates were so low in recent months because of one-off factors (price drops for wireless phone service and prescription drugs). The Fed expects inflation to move up and stay around two percent over the next two years, but plans on monitoring it closely.
Many are taking a critical stance on this decision, arguing that the Fed may be putting the country at risk of deflation based on recent trends. Yellen’s oblique rejoinder: “The rate does not have to rise all that much further to get to a neutral policy stance.” The rate hike is a thumbs-up from the Fed on the current state of the US economy but some indicators are ambivalent so analysts are divided.
To be noted — Yellen expressed support for much of the Treasury report’s policy recommendations published Tuesday, but took exception to some of its key systemic and other recommendations.
• Policy Direction — The capital, especially bond, markets have already discounted (priced in) a 25 basis point Fed interest rate increase today, with one more such hike expected in calendar 2017. Attention will be paid to anything that suggests this market consensus forecast is wrong or that clarifies the direction of Fed interest policy later this year or beyond.
Yellen spoke at length, reaffirming the Committee’s normalization policy but emphasizing its flexibility. Following today’s action, the market doesn’t know if the Fed will continue its pace of a 25 bp rate hike per quarter or slow to just one more hike this year, its clear preference. Today, markets are calling two percent the new normal; the Fed says closer to three. In the past, the Fed has eventually converged with earlier market expectations. Markets shed about a percent across the board during Yellen’s appearance this afternoon.
• Economic Forecasts — The Fed will publish updates of its own consensus projections for the key indicators in setting rate policy, e.g., inflation, unemployment and wages, productivity, GDP growth, etc. Any projection that is a surprise to the market or relates to sensitive data, especially on growth, is at the center of both political and market debate.
The only mismatch between the market read and Fed analysis is on the current “natural” interest rate — which the Fed now estimates at three percent while market participants say closer to two.
• Fed Balance Sheet — The Fed expanded the total assets held on its balance from under $1 trillion in 2008 to nearly $4.5 trillion in 2014, which is roughly where it has sat since. The Fed has long expressed its intent to scale its holdings back, but nothing is known about when the deleveraging is to begin, its pace, and the extent of the Fed sell off. It is concerned that market participants may not appreciate what massive deleveraging might mean for global bond markets, where large investment flows into bonds continues unabated.
Yellen made clear that the Fed’s program to reduce its balance sheet will begin modestly, take years, and will barely move markets.
• Unemployment — The Fed met the last two days in the context of paradoxical labor market conditions. The official unemployment rate is 4.3 percent, lower than the 4.5 percent mark the Fed predicted by the end of the year. This low rate officially amounts to full employment — fulfilling one half of the Fed’s dual mandate for maximizing employment and stabilizing inflation. The Board’s optimism about the labor market is sufficient to reduce its long-term unemployment rate projection from 4.7 to 4.6 percent.
• Labor Force Participation — The unemployment rate should not satisfy regulators on its own. Last month, the labor force participation rate fell to 62.7 percent. From the late 1980s to the onset of the Great Recession in 2007, the rate stood at or around 66 percent. Still, the rate has been stable since June 2014, which Yellen reads as a sign of improving conditions in the context of an aging US population. Yellen believes further that consistent job gains of 160,000 per month are sufficient to accommodate new entrants to the labor force. Yellen pointed to the following indicators to demonstrate the labor market’s health:
– Household perception of the availability of jobs
– Number of job openings
– Rate at which Americans quit their jobs to pursue new opportunities
– Increased business investment and hiring
• Job Training — In response to a question soliciting her views on Pres. Trump’s proposals to cut job training programs, Chair Yellen indicated she believes state- and locally-administered training programs work. It is important to note that many federal programs create funding streams for such local entities. Therefore, cuts to these programs imply the abandonment of effective state and local training programs. Her reference to the non-for-profit sphere can be read as a surrender to inevitable administration cuts to critical job training programs.
• Wage Growth — Wage stagnation may have given the Fed pause in its deliberations on raising rates. Increasing interest rates could damage worker wages, as more expensive borrowing could mean businesses opt against boosting pay. Yellen hinted at concern for the labor market by referencing a long span over which inflation has failed to meet the Fed’s 2 percent target. Wage growth has historically been closely tied to inflation, so low levels of inflation suggest low levels of wage growth. Yellen did mention in her testimony today that inflation is having little to no effect on wage growth and vice versa.
In response to concerns, Yellen has cited Federal Reserve Bank of Atlanta data demonstrating a rise, albeit slow, in wage growth to over 3 percent — up from 1.6 percent during the trough of the Great Recession.
Yellen and Trump, after his less-than-amicable comments about her and the Fed during the campaign, seem to have struck up a functional relationship. In April, he didn’t rule out re-appointing her as Chief at the end of her term next February. But he praised her as a fan of “low rates” and the president can’t be happy about the prospect of uninterrupted rate hikes through his term.
One of the reasons the Fed may have waited on raising rates at its previous meeting in May is that, at the time, markets expected one of more outsized Trumpian stimulus bills (tax reform or infrastructure spending) to clear Congress. Over the last couple of months, it had become inescapably clear that both are letting that promise fall to the wayside. Today’s move by the Fed confirms this view. The Fed did not want to be in the position of having to blunt the effects of a macro-economically gratuitous stimulus when the recovery glass was half-empty. Today it is half-full.