Yellen Testimony

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Via Stephen Stanley at Amherst Pierpont Securities

Chair Yellen's testimony was broadly similar in tone (as you would expect) to her June 6 speech as well as her press conference six days ago. Here are the key themes:

Optimistic on the Growth Outlook: At the time of the April FOMC meeting, the Committee was concerned about the growth outlook. GDP growth for Q1 was about to print near zero, and officials were especially concerned about the fact that consumer spending growth in real terms had slowed despite what seemed to be still-robust underlying fundamentals. The April retail sales report turned the tide, setting the stage for a solid rebound in growth in the spring. The Fed seems back to being broadly optimistic about growth. Business investment remains soft, but household spending looks to be back on track, housing is solid, and the drag from net exports is likely diminishing. Meanwhile, the periodic concerns emanating from the unsteady global picture for the moment have receded, at least for now.

Worried about the Labor Market: As late as April, the labor market situation was viewed as rock solid, even as growth concerns were substantial. Now, the situation has flipped. The growth outlook is back on track, by and large, but the May employment report threw Yellen and the FOMC for a loop. In the most ironic passage of the testimony, Yellen asserts that "it is important not to overreact to one or two reports," but this is almost certainly what the Fed has done in the wake of the soft May payroll figures. Yellen acknowledges that "several other timely indicators of labor market conditions still look favorable," so the Fed thinks that the labor market is still in good shape, but the level of confidence is sufficiently low that I suspect the June employment report will be one of the more important ones in a long time.

Inflation Moving Toward 2%: The FOMC is much more relaxed about the inflation picture than it was, say, a year ago. Rarely do we hear discussion about inflation being too low any more. Instead, "the FOMC expects inflation to rise to that level (2%) over the medium term." She noted that as the drag from falling energy prices and lower import prices fade, inflation should move up from current levels toward 2%. She also noted in the context of the labor market discussion that there are "tentative signs that wage growth may finally be picking up."

Lots of Uncertainty: It has been said that Fed officials are paid to worry, and Chair Yellen is a world-class worrier. She listed the various risks that the Fed is eyeing. She notes that domestic demand may falter, citing the latest employment report as well as weak investment. She mentions that low productivity growth could be a permanent fixture in the landscape. Third, she notes that global vulnerabilities remain, mentioning China. She repeated her point from June 6 that "investor perceptions of and the appetite for risk can change abruptly." Finally, she cites the possible fallout from a Brexit vote.

Cautious Policy Outlook: Yellen notes that "proceeding cautiously in raising the federal funds rate will allow us to keep the monetary support to economic growth in place while we assess whether growth is returning to a moderate pace, whether the labor market will strengthen further, and whether inflation will continue to make progress toward our 2 percent objective." This would appear to encapsulate the Fed's strategy in a nutshell. In fact, I would say that to describe the Fed as "cautious" would be an understatement. The FOMC seems to need everything to line up perfectly to feel comfortable with a rate hike. Just when one problem goes away, another one pops up, like a game of whack-a-mole. She also repeats the idea that with rates near zero, risks are asymmetric, because the Fed has limited room to respond if things go south. I'm not sure when this argument will expire, but the due date would seem to be coming up soon. You can't keep policy super-easy forever.

She concludes with the construct that she fleshed out on June 6 that structural headwinds (global drags, subdued household formation, and meager productivity growth) may be depressing the equilibrium interest rate for the economy. The Fed's view is that these headwinds will lift gradually, which argues for gradual rate hikes and the Fed adjusts policy to track changes in the equilibrium rate.

Of course, this assumes that the current policy stance is reasonable close to neutral, but she acknowledges that the current stance of policy is accommodative, so if the Fed grows complacent or continues to find excuses not to raise rates even as the general environment dictates it, then the Fed will fall behind the curve. There will be no urgency on the part of the Fed until inflation actually moves to and perhaps through 2%, but that may come quite a bit sooner than the Fed expects. In any case, the Fed is very much data dependent, so the track of policy moves going forward will evolve as the data do. I still see scope for two moves before year end (September and December), but obviously there is not much wiggle room on that call any more.