Mrs Yellen and her testimony to Congress

Fed Chair Yellen used her semiannual Congressional testimony last week to present a defense of continued exceptionally easy monetary policy, yet the dovish rhetoric included acknowledgement of improved labor market data, the FOMC’s desire to form an exit strategy, and identification of pockets of financial excess.
As background, the Fed now seems closer to achieving its dual goals of price stability and maximum employment today than at any point since onset of the global financial crisis with jobs growth strong, unemployment falling quickly, inflation still below target with signs of bottoming, and whilst GDP growth faltered in Q1, recent indicators point to a rebound in Q2.
Against this backcloth, Mrs Yellen could have hinted that the need for ultra-easy monetary policy is nearing an end but instead she focused on “significant slack” remaining in the jobs market, “disappointing” housing activity, and the “false dawns” of the past, stating that the economic situation called for a continued “high degree of monetary policy accommodation.” The tone of her testimony conveyed no urgency to tighten rates and rather she expressed the need for caution during a recovery that “is not yet complete” and while the FOMC currently judge the risks for economic growth, unemployment and inflation to be “nearly balanced,” Mrs Yellen said they “warrant monitoring in the months ahead.”
Yet there was an adjustment in Mrs Yellen’s text from that of her 18th June post-FOMC press conference, acknowledging that the labour market is improving faster than policymakers expected (see appendix) and the FOMC’s record of forecasting has been poor, being too optimistic and on the way down, and generally too pessimistic on the recovery. If the data continue strong, the Fed may feel more confident in lessening some of its “exceptional” accommodation.
On the issue of excesses, zero interest rate policy for over five years has left the Fed in the difficult position of promoting risk taking while simultaneously trying to discourage formation of asset bubbles. Mrs Yellen explained that the Fed is monitoring financial conditions by looking at broad measures of leverage, the extent of maturity transformation and credit growth, and the behavior of broad equity indexes. In her testimony, Mrs Yellen argued that prices and valuation metrics of “real estate, equities, and corporate bonds…remain generally in line with historical norms,” and she currently does not see serious threats to financial stability – but Mrs Yellen identified pockets of concern in sectors “such as lower-rated corporate debt” adding “we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance.” The risk is that such stretched valuations expand and multiply, and while she made clear her preference to use macro-prudential policy rather than monetary policy to control financial excess, she noted that sustained low interest rates “could increase vulnerabilities in the financial system to adverse events.” Looking forward financial excesses could be one factor that drive the Fed to tighten policy.
It is clear that the Fed wants to avoid curtailing the US expansion with premature tightening, but Mrs Yellen and the FOMC will be aware that overly easy policy and excessive suppression of volatility can create risks of their own which could jeopardize the expansion’s longevity.
As to what lies ahead, we suspect that the stand-off between improving data and exceptionally accommodative policy will shift to more hawkish rhetoric later this year and an initial interest rate hike by late next year.
The onus on shifting rhetoric is because arguably the real challenge for the Fed is likely to be that when the time to raise rates does come, they will have difficulty in convincing markets that the goal is not to restrict growth with tight policy, but rather to begin normalizing financial conditions with policy more appropriate for recovering economic conditions. We will monitor Mrs Yellen’s statements for more clues on the policy agenda, and gauge market reactions to determine how the first rate hike will be taken when it does come.

Appendix

15th July 2014: “…the Committee’s decisions about the path of the federal funds rate remain dependent on our assessment of incoming information and the implications for the economic outlook. If the labor market continues to improve more quickly than anticipated by the Committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned. Conversely, if economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated.”

18th June 2014: “Let me reiterate, however, that the Committee’s expectation for the path of the federal funds rate target is contingent on the economic outlook. If the economy proves to be stronger than anticipated by the Committee, resulting in a more rapid convergence of employment and inflation to the FOMC’s objectives, then increases in the federal funds rate target are likely to occur sooner and to be more rapid than currently envisaged. Conversely, if economic performance disappoints, resulting in larger and more persistent deviations from the Committee’s objectives, then increases in the federal funds rate target are likely to take place later and to be more gradual.”