In previous commentaries I argued that when the FOMC morphed the time reference “considerable time” in its policy statement to the word “patient” and subsequently to words that participants painstakingly described as “data-dependent,” forward guidance was effectively dead. Saying that policy in the future will depend upon the flow of incoming data provides no useful information to market participants. Indeed, what else would or should a policy decision be based upon? We are not in the rules-based world envisioned by Milton Friedman, where the monetary base is increased at a fixed rate. Even the Taylor-rule world proposed by some makes policy changes based upon incoming data. The fundamental questions are, what “incoming data” will factor into decisions and how will policy depend upon those data?
Delivered only a week after the most recent FOMC meeting, Chair Yellen’s March 27 speech at a research conference, “The New Normal Monetary Policy,” held at the Federal Reserve Bank of San Francisco, was arguably a game changer in many respects when it comes to clarifying Fed communications on policy and advancing the concept of forward guidance. Chair Yellen provided substance, depth, and breadth with regard to what data are important to the FOMC’s decision making. She indicated both how and why those data are important; and, finally, she also provided the analytic and conceptual framework for the decision-making process by referencing the research and models that were the underpinnings for the FOMC’s deliberations. The speech went a long way toward addressing the fact that market participants, unlike the general public, require more than just vague language and expressions of the need to keep policymakers’ options open when they contemplate taking positions that can put considerable assets at risk. Surprises, like the Swiss National Bank’s recent decision to drop the currency peg with the euro, are both unfair to market participants and systemically disruptive.
So what are we to glean from Chair Yellen’s San Francisco speech? She posed and addressed three issues.
First, why does the Committee judge that an increase in the federal funds rate target is likely to become appropriate later this year?
Second, how are economic and financial considerations likely to shape the course of monetary policy over the next several years?
And, finally, are there special risks and other considerations that policymakers should take into account in the current environment?
In assessing current economic conditions, Chair Yellen specifically noted the progress of the recovery but cited three indicators suggesting that substantially more improvement is needed. GDP growth has been moderate, but four indicators of labor market conditions are still subpar: the unemployment rate is still above the Committee’s 5% to 5.2% estimate of full employment; involuntary unemployment is still high; the participation rate is still lower than expected; and wage growth is still subdued. Her analysis is backed up by solid research on labor markets and not just referenced to a few statistics. She also emphasized that despite progress on the real side of the economy, there has been little movement toward achieving the Committee’s inflation objectives. Again, her belief that inflation will gradually pick up is backed not only by detailed discussions of productivity and wage growth but also by research indicating that inflation is likely to increase as labor markets improve and slack diminishes.
The picture that emerges from this rather cautious evaluation is that while progress has been positive, the economy is far from robust. This is despite what has been historic policy accommodation. In the face of this sober assessment, why, in answer to the first of the three questions Chair Yellen posed, might the Committee conclude that an increase in the policy rates might be warranted sometime this year? Key among the reasons she cites is the observation that monetary policy acts with a lag, and to wait risks overshooting the Committee’s inflation and employment objectives, a miscalculation that would then call for a policy reversal that might further damage the economy. In fact, Chair Yellen is quite specific in terms of her own assessment of how incoming data might reflect her willingness to support liftoff: “… 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.” In short, Yellen sees a moderately growing economy, but one supported by historic policy accommodation, with a) considerable slack in labor markets, b) an equilibrium real rate considerably below historic levels, and c) considerable uncertainty about the prospects for continued growth, absent the zero interest rate policy. The inference is that further reduction in labor market slack, improvement in wages, and a pickup in both overall economic and inflation expectations are critical preconditions to the timing of the first rate move. None of these are yet evident.
As for the second question she posed concerning the likely course for policy in the future, she tries to disabuse her audience of the view that policy will necessarily proceed with systematic gradual steps. She states that, “… 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.” Here she falls back upon the point being emphasized by most FOMC participants, that the actual path will be data-dependent. She indicates that FOMC participants’ outlooks and forecasts will be crucial. Having said that, there are reasons, which are outlined below, why the policy path is likely to be gradual.
One side observation is warranted here. In her discussion of the policy path, Chair Yellen emphasized the role of market expectations and the Committee’s objective to shape those objectives as being most important: “… what matters for financial conditions and the broader economy is the entire expected path of short-term interest rates and not the precise timing of the first rate increase.” This observation suggests that one should keep a sharp eye on market measures of expected future short-term interest rates and how they map to FOMC participants’ SEP (“Summary of Economic Projections”). Here, given the emphasis on the nexus between expectations and FOMC forecasts for both the economy and the policy rate, markets would be better served if the Committee refined its projection process by providing the quarterly medians and ranges for the SEPs rather than simply the annual values. The annual SEPs are simply not granular enough, given their likely importance in helping to shape market expectations.
Turning to Chair Yellen’s final question, concerning the special risks the Committee should consider, she cites three potential concerns. The first is uncertainty about the equilibrium real interest rate and whether there has been, as recent research argues, a permanent reduction in that rate due to the aging of populations in many of the world’s major economies, including the US. If there has been such a downward shift, it could affect the economy’s ability to adjust to a given interest rate and rate path, and might mean policy normalization would need to be more gradual and the equilibrium policy rate lower than has been the case in past recoveries.
The second concern is uncertainty about the dynamics of market responses to policy movement towards normalization in the vicinity of the zero lower bound for the federal funds rate. It is possible that the economy and inflation could rebound more rapidly than projected, overshooting the Committee’s objectives and causing the Committee to reverse course. On the other hand, Yellen also emphasized that the initial response might cause the economy to falter, leaving the Committee with little or no ability to lower the policy rate and thus compelling the FOMC to engage in more quantitative easing. Given the size of the Fed’s balance sheet and questions about the marginal effects of additional asset purchases, policy could be trapped. She notes that while FOMC participants see these risks as balanced, such is not the case for market participants, who are more pessimistic about the growth prospects for the economy and the likely negative impacts that international developments could have on the US economy. Both factors would call for a more gradual path than that projected by the FOMC.
The third argument for a gradualist approach to policy tightening concerns the ability of the Committee to achieve its 2 percent inflation objective. A more gradual approach would foster less slack in labor markets and result in a more prompt ascent of the inflation level to the Committee’s goal while at the same time helping to put more people to work and bringing more workers back into the labor market.
True to the Committee’s risk-management approach to policy, Chair Yellen also gives voice to the arguments against the more gradual approach and the costs it might entail. These include (1) the risk of overshooting the Committee’s inflation objective and thereby undermining its credibility, (2) the risk of adversely affecting financial market stability by supporting undue leverage and relaxation of credit standards, and (3) the risk of further distorting the functioning of financial markets.
This speech goes a long way towards fleshing out our understanding the kinds of data the FOMC is taking into account and how those data will impact decision making. But it also suggests how the Committee is likely to proceed as it assesses incoming data and implications for the path of policy. As for putting incoming data in the context of the framework that Chair Yellen laid out, clearly the effects of this winter on consumer spending, the slowdown in housing, and the weak jobs report for March would clearly bolster her concerns about the robustness of the recovery and increase the perceived risks that could come with a liftoff by mid-year that some have suggested might be in the offing. Caution and risk aversion are likely to play an important role in future decisions and, at least from this writer’s perspective, this now suggests further support for a September liftoff at the earliest and perhaps much later in the year. This likelihood argues for a continuation of low rates and will be bullish for equities.
But most important of all, the speech provides a roadmap for the kind of detailed discussion and analysis that puts real meaning to the term forward guidance. It remains to be seen whether Chair Yellen will continue this policy after subsequent FOMC meetings, but it certainly would be a welcome change in FOMC communications policy.