Fed: Will Yellen do a Carney?

Published on July 1, 2014

The question, brusquely poised in the shorthand of the headline, is being asked across the fixed income markets these days amid the seeming complacency of rates pricing, namely, whether Federal Reserve Chair Janet Yellen might unexpectedly signal a shift in the Federal Open Market Committee’s dovish forward guidance towards a more hawkish stance in one of her upcoming public remarks and testimonies in the same way Bank of England Governor Mark Carney did a few weeks ago.

Chair Yellen, for instance, will be speaking this Wednesday morning at the International Monetary Fund, and later this month — the date has yet to be set — she will be giving her mid-year Humphrey-Hawkins testimony on Capitol Hill. And, of course, she is slated to give the key note speech at the Kansas City Federal Reserve annual retreat in Jackson Hole at the end of August.

The short answer is no – at least not yet.

*** Neither Yellen nor the FOMC majority think there is a need to signal a hawkish turn any time soon. They are much more likely to wait until at least the September meeting (SGH 4/22/14, “Fed: Twists and Turns”) for enough data to confirm their confidence the recovery is indeed nearing the much sought “escape velocity.” What’s more, any shift to a more hawkish forward guidance is more likely to come in the formal statement rather than a speech, probably evolving over several meetings, as it did in the run up to the June 2004 rate hike. ***

*** At most, we expect Chair Yellen’s comments on Wednesday to adhere closely to the Committee’s June consensus: cautious optimism on the pace of the recovery despite the first quarter GDP numbers, and perhaps framing the “noisy” inflation data in the context of an uptick to a non-threatening 1.5% to 2% range for core PCE  from the previous 1% to1.5%. We suspect Chair Yellen will also offer a bit more detail on the Fed’s “balanced” approach to the inflation/unemployment trade-off as well as on the “below normal” neutral rate — but only a bit more. ***

*** Indeed, some of these key themes shaping policy are for now best left vague to maintain as much of a Committee consensus going into later this year when the pressure will build for a shift in guidance. Speaking as the Chair, Yellen may at times seem slightly more hawkish than expected, for example in reaffirming the Fed’s 2% inflation target or in noting an uncertainty that would suggest less market exuberance, and she will in fact be just as willing to adopt a more hawkish stance if the data goes against what is still the Fed’s more patient reaction function. But until then, Yellen is likley to avoid any signaling for the moment that would indicate the balance of risks are tilting to the upside, which are still many months away. ***

Differing from Carney (and the BIS)

The UK economy is, of course, in a far different, more advanced stage of the recovery than the US. And its housing market is well ahead of the still struggling US housing; but more specifically, the BoE was late to utilizing forward guidance as a viable unconventional policy tool, so Governor Carney was always operating with more than just a small handicap on that front. It is also a bit tougher to offer coherent forward guidance when policy is by published vote rather than the collegial consensus style of the FOMC.

Perhaps more to the point, while Carney may have taken sizable hits to his credibility and that of the Bank, on the other hand he seems to have succeeded in quelling some of the excessive risk behavior through his rhetorical pirouettes, for short rates rose after his shift to earlier hikes while the longer end of the curve remained well anchored.

Yellen would love to be so lucky that lobbing a few rhetorical salvos would be enough to dampen the excessive risk-taking fervor without upending the middle of the curve where most of the transmission of policy into the real economy — mortgages for instance — is priced.

For certain, asset price inflation rather than goods and services inflation is the nearer term risk to the Fed’s current policy path. The Bank for International Settlements said as much in its just released Annual Report and the opinion-threaded concluding chapter that drew so much media attention yesterday. Its reported admonishments aside, however, the Fed would be in perfect agreement on the risks to financial stability if low rates continued for too long — but they aren’t a risk yet; that is her story and she and the majority of her colleagues are sticking to it.

The probabilistic costs at this point in derailing the recovery with a premature rate tightening versus the possibility of deflating a potential asset price inflation that might prove costly down the road is such that the fight or flight moment is simply not here yet; nor will those low rates flattened against the zero lower bound last for all that much longer. It is hardly a coincidence the FOMC is working across its current meetings to recast the new sequencing to its Exit from unconventional policy.

More importantly, as the debate over the curious first quarter GDP numbers testifies, the question going forward if the policy path is to finally take its hawkish turn to counter upside risks is less about growth or the quarterly projections for real growth, but rather where and when the forecasts are likely to put the trade-off between lower unemployment and higher inflation.

Along those lines, the barometer to whether the economy is at full employment or inflation is in danger of moving with persistence above the 2% medium term inflation target is the behavior of wages and unit labor costs. The headline unemployment rate in the Nonfarm Payroll number this Thursday, for instance, is less pressing to Fed officials than its breakdown and, in particular, the trend or lack thereof in what they hope to be ever so slowly rising average hourly and weekly earnings.

Patience on the wage-inflation trade-off

An elastic link between a faster rise in wages and sustained price pressures that warrants patience in allowing wages to rise at a faster pace than what the central bank may have previously tolerated for fear of undesirably strong price pressures is a core principle to the Yellen-led policy path going forward. And it bears some elaboration as it may emerge as a theme on Wednesday or in subsequent testimonies or speeches.

For now, wage growth is running at barely 2.1% and has been at near stagnant levels for a decade or more. A sustained wage growth of 3.0% or 4% is for now seen by the Fed as a cornerstone to the sort of aggregate demand growth needed to sustain the recovery.

But in the Yellen labor market, workers may prove to be reluctant to return to the labor force until they see more opportunities as the headline unemployment rate falls and above all, are enticed back by wages that are rising again. That is why the Fed believes the decline in the headline unemployment rate will tend to slow in the coming months as more workers are pulled back into the labor force.

In the downturn, employers were reluctant to cut wages but are proving to be just as reluctant to raise wages in the recovery until they see more than enough sustained demand. In the stand-off that ensues, the bet the Fed is willing to make is to show patience in keeping conditions accommodative enough to foster sufficient demand to push wages up and pull still more workers in.

At the same time, inflation never went negative in the great recession as the models indicated it could when the output gap was so deeply negative. It instead fell to very low levels, trending sideways, perhaps held to its low inflation floor by anchored inflation expectations.

Inflation may have persisted at this lower level last year for longer than anticipated — the aggressive accommodative stance under the optimal control path the Fed has essentially pursued since 2008 was supposed to have resulted in temporarily higher, not lower inflation — but the same inertial tendency applies to the upside, with only a modest, delayed upward tilt as the economy recovers, the output gap closes, and wages are slowly rising.

Yellen is likely to make that case in cautioning against a degree of noise in the most recent CPI headline. In this case, the uptick in price pressures has simply reflected the reversal in those previous unexpectedly persistent downward pressures, and what’s more, some of the upward measures in the index that tend not to persist for very long and will soon fade in impact — noise in other words.

Instead, more likely is that last year’s persistence in low inflation in the 1% to 1.5% range, that had threatened to turn further south if demand ebbed, has now up-shifted to a new higher range between 1.5% to 2% for a while. For Yellen and like-minded Fed officials, this anticipated modest rise in the price data is essentially providing some relief the low inflation risk is ebbing rather than triggering any new angst over a sustained upward spike in inflation.

And in the process, the Fed’s reaction function in weighing deemed lower probabilities of sustained  inflation relative to the prospects of gains to jobs and a higher longer term trend growth could be undergoing a change by the time the Exit approaches.

The Meaning to a “Balanced” Approach

In pulling the FOMC into her case for the labor-inflation trade off, however, Yellen as Chair has had to carefully craft her words to balance her strongly held views on the labor market and wages with the avowed goal to maintain price stability. She is, after all, as we wrote previously, a tactical rather than ideological dove (see SGH 6/22/14, “Fed: Twists and Turns”).

In March, for instance, in return for the “below normal” interest rate sentence in the statement, she noted in the presser that inflation “operates with a lag” and will be carefully monitored. And in her most recent presser, she was careful to avoid conveying any willingness to overshoot the 2% inflation target or to even say the target is symmetric and not a ceiling.

Instead, she stuck to a cautiously worded phrasing about a “balanced” approach in which “if the distance from achieving an objective is particularly large, it would be consistent with a balanced approach that we would tolerate some movement in the opposite direction on the other objective.”

That by any account is (nearly) the same as indeed affirming a willingness to tolerate an overshoot of the inflation target and perhaps to even let it go for a while if deemed necessary to push unemployment even lower if a sustained rise above target is not in the forecast.

But that is a debate not for now, but for much later in the year, when the Fed is that much closer to its mandate-consistent targets for both inflation and unemployment. Not even all the more dovish-inclined are on board with an overshoot of the target, and until the pressure is building for a shift in guidance to acknowledge a balance of risks tilting to the upside, there is not much to be gained in pressing the issue now.

It remains far better from a tactical view to maintain a Committee consensus on the near term policy path for as long as possible without dissents — indeed, it has largely gone unnoticed Yellen has now led two meetings with no hawkish dissents that had marked almost every meeting during Chairman Bernanke’s tenure.

Back to list