By Alliance Bernstein
In a speech before the Economic Club of New York on Tuesday, US Federal Reserve Chair Janet Yellen articulated a very dovish stance. She also suggested - in our view - that the Fed's course of action hinges on a rationale that is no longer primarily economic.
A Change in Forecast or a Shift in Reference Point?
Ms. Yellen stated that the Fed's "baseline outlook for real activity and inflation is little changed" from the start of the year. That's no surprise to us. However, she gave us pause when she provided the reason for this stability in the outlook: "Downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates."
That's an interesting statement. Let's dig into it.
At the start of 2016, the Fed's baseline outlook for growth and inflation included four rate hikes over the course of the year. The Fed is now arguing that, despite oil and stock prices being back at December levels and with market interest rates lower since the initial forecast, today's unchanged baseline forecast is somehow consistent with only two rate hikes.
Yellen's argument just doesn't add up. It strikes us that policymakers must have altered something - and if it's not their forecasts for growth and inflation, then they must have shifted their main data reference points from economics to financial markets. Indeed, this seems very likely.
If it's true, then the markets may be looking to the central bank, while the central bank is looking to the markets.
Potential Stock-Market Declines Warrant Delay in Rate Hikes
Yellen might have best explained the current state of monetary policy when she said, "Monetary policy will, as always, respond to the economy's twists and turns." Yet what turns more than the economy may be the Fed's policy framework.
In December, Yellen described her policy position in this way: "Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly at some point to keep the economy from overheating and inflation from significantly overshooting our objective." That statement dovetails with the Fed's traditional economic-data reference points, such as the jobless rate and core inflation.
Three months later, she appears to have reversed course rather severely, making it clear that global financial events now weigh heavily on monetary policy, and that as long as the global financial outlook remains fragile, a dovish policy is the most likely course of action.
Indeed, throughout her comments on Tuesday, Yellen placed a lot of emphasis on financial conditions. Falling stock values - often linked to "recent declines in oil prices" - were described as a tightening of financial conditions. Hence, they apparently warrant a delay in rate hikes, if not a reversal. (One wonders why rising stock values are not seen as easier financial conditions, warranting a hike in official rates; perhaps one day, they will be.)
And although oil and stock prices have returned to December levels, Yellen and other policymakers are clearly worried about continued stock-market volatility and the future price of oil, either up (bad for household incomes) or down (bad for inflation expectations).
China's economic growth is also a concern for policymakers. The question is, is that because there has been a change in its trajectory since December, or because the Fed has decided that the markets pay a lot attention to it and the Fed is now paying more attention to the markets?
The bottom line? No change in official rates until June at the earliest. And the key variables? Stock values, the price of oil and China's growth rate, more so than the US jobless rate, wages and core inflation.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.