- New Fed Chairs typically pursue hawkish policy in order to constrain long-term inflation expectations.
- Yellen's statement about raising rates in six months was not a gaffe, it was a deliberate hawkish signal.
- Investors should expect hawkish language coming from Janet Yellen over the next couple of months.
Last week new Fed Chair Janet Yellen shocked markets when she suggested that interest rates might rise in roughly six months. This came as a huge surprise because Yellen was perceived to be one of the most dovish members of the Federal Reserve Board and because she is the one who designed the Fed's current, dovish forward guidance strategy.
Despite the widely reported market shock, several astute commentators have pointed out that while the stock market dramatically reacted to Yellen's comments, the bond market's reaction was much more staid. In fact, the bond market reacted almost exclusively to the FOMC press release, not to Yellen's comments. Some have suggested that this is because the bond market reacts to changes in policy, not to changes in guidance, but fluctuations in bond prices over the last year have suggested just the opposite. Bond markets definitely react to forward guidance. So, why did equities react so violently while bonds remained calm?
The most likely answer is that the bond market had already priced in Yellen's hawkish sentiment. But how can that be? Everyone knows that Yellen is a dove and that her 6-month statement was just a gaffe, right? Wrong.
Janet Yellen is known for being over-prepared for everything she does, so why would we look at any statement in her very first post-meeting press conference as Chair as a mistake? It is completely out of character for her to make such an error. More importantly, her statement was perfectly consistent with her new position as Chair.
Looking back at the last three Fed Chairs (covering nearly 35 years) all three have one thing in common, they all pursued tighter policy immediately upon entering office:
- Paul Volcker raised interest rates 400 basis points in his first six months as Fed Chair.
- Alan Greenspan raised interest rates 50 basis points in his first month as Fed Chair.
- Ben Bernanke raised interest rates 75 basis points over the course of his first three meetings as Fed Chair.
This trend is completely logical. Given that Fed personnel have almost always considered low and stable inflation paramount, new Fed Chairs know that their primary responsibility is controlling long-term inflation expectations. The easiest way to signal that you are tough on inflation is to raise interest rates immediately upon entering office. Since Janet Yellen can't do that in the current situation, she did the next best thing, she signaled that is willing to raise rates much sooner than expected. This move caused equities analysts to panic, but bond traders, who are used to watching new Fed Chairs come in and talk tough, barely even flinched.
Not Hawkish Enough
The question investors should be asking themselves after Yellen's planned "gaffe" last week is whether it was hawkish enough. We all know Janet Yellen as a dove, so the question is whether mentioning the possibility of raising rates a few months earlier than expected is really enough to establish her credibility as an inflation fighter. I suspect it is not.
Yellen is walking a very fine line here. She has to manage market expectations that she will support easy money while still signaling that she is willing to do what is necessary to keep long-run inflation expectations in check. Sure, high inflation is not currently a problem in the U.S., but Yellen's hawkish signal was as weak as they come: First, it was part of an off-the-cuff remark, not a prepared statement. Second, it was only part of Yellen's press conference, not in the language of the FOMC statement. Third, she never signaled that the Committee would be accelerating the pace of tapering. Simply, this was the most dovish of all possible hawkish stances.
What to Expect
Despite the reporting on Yellen's statement as a gaffe or blunder, history suggests that she was doing exactly what other Fed Chairs have done by signaling tighter policy upon taking the helm of the Federal Reserve. Given the behavior of past Chairs, it is highly likely that Yellen will continue to pursue a surprisingly hawkish posture for at least the next two FOMC meetings. Furthermore, our FPSI data suggests that Yellen's sentiment toward the economy has been consistently above trend for the last couple of years and rising; Yellen's rising sentiment reinforces her hawkish posturing.
The bottom line is that new Fed Chairs talk tough to constrain long-term inflation expectations, so we should expect to see more of Janet Yellen the hawk over the next few months. Although it is largely just posturing, Yellen's tough talk will likely cause interest rates to rise modestly while putting downward pressure on stocks over the next few months.
Additional disclosure: Along with my colleague, William MacMillan, I hold a pending patent on the methods for examining central bank communications that are referenced in this article. Further details about this data can be found on our website, FedPlaybook.com.