On the edge of potentially critical elections in Greece that could trigger coordinated action from global central banks (see "Central banks ready to combat Greek market storm" from Reuters), I decided to summarize the last two speeches from U.S. Federal Reserve Vice Chair Janet L. Yellen given her strong advocacy for pro-active intervention on behalf of the U.S. economy. If her arguments hold sway over the rest of her colleagues in the Federal Reserve, it seems to me that the Fed will quickly act to ease monetary policy in the wake of any further deterioration of conditions in Europe. Given these prospects, I have become increasingly bearish on the U.S. dollar which has still failed to surpass its "QE2 reference price" - the level the dollar index (UUP) held immediately before Chair Ben Bernanke telegraphed a second round of quantitative easing. Moreover, I expect any action to increase liquidity in global financial markets will heavily rely on increasing the availability (or even supply) of U.S. dollars.(click to enlarge)
Despite growing angst about Europe, the dollar index has failed to make further gains since hitting the QE2 reference price two weeks ago
Last week, June 6th, Yellen delivered a speech at the Boston Economic Club Dinner, Boston, Massachusetts titled "Perspectives on Monetary Policy" in which she repeated the case for extending highly accomodative monetary policy. Just two months earlier, April 11, she made explicit the framework she uses for determining the appropriate monetary policy. That speech came at a time when the S&P 500 (SPY) had recently come off multi-year highs, and analysts were beginning to speculate that recent Fed minutes indicated increasing hawkishness. Yellen undercut such talk, and poor employment numbers since then have completely silenced hawkish musings.(click to enlarge)
Is the market listening to Yellen? Her last two speeches have conveniently come at the end of sell-offs.Source: FreeStockCharts.com
In "The Economic Outlook and Monetary Policy" (April), Yellen concluded that "risk-management considerations strengthen the case for maintaining a highly accommodative policy stance longer than might otherwise be considered appropriate…Given the unprecedented nature of the current economic situation and the limits placed on conventional policy by the zero lower bound on interest rates, these issues of risk management take on special importance." Yellen is concerned that if the Federal Reserve is not proactive in staving off a deeper economic malaise, the Fed could find itself taking on very large risks and costs trying to deliver substantial easing with rates already at zero. Yellen insists that if the economy becomes stronger than expected, the Fed has plenty of scope to tighten (I continue to doubt the Fed will be quick to tighten even when the data finally indicate it should). In other words, Yellen will certainly err on the side of accommodation and stimulus if there is any risk that the economy might slip from an already undesirably slow recovery.
In fact, Yellen insists that today's accommodative policy is not loose enough, especially because of the constraint of the zero lower bound on (nominal) rates:
"Importantly, resource utilization rates have been so low since late 2008 that a variety of simple rules have been calling for a federal funds rate substantially below zero, which of course is not possible. Consequently, the actual setting of the target funds rate has been persistently tighter than such rules would have recommended. The FOMC's unconventional policy actions-including our large-scale asset purchase programs-have surely helped fill this 'policy gap' but, in my judgment, have not entirely compensated for the zero-bound constraint on conventional policy. In effect, there has been a significant shortfall in the overall amount of monetary policy stimulus since early 2009 relative to the prescriptions of the simple rules that I've described."
Yellen's speeches fascinate me because she describes in explicit, technical detail the specific machinery she uses to assess options for monetary policy while recognizing "…the limits of our understanding regarding the dynamics of the economy and the transmission of monetary policy." Yellen describes three tools for setting monetary policy: the Taylor rule with a moderate response to slack (1993), the Taylor rule with double the response to slack (1999), and optimal control techniques which seek to minimize the costs of deviating from targeted inflation and long-run unemployment rates. Yellen prefers the optimal control policy because it delivers accommodation for a longer time and thus provides insurance against additional downside risks in economic performance. The optimal control policy keeps the Fed funds rate near zero into 2015, drives unemployment down faster, and generates slightly higher inflation.
Economic Outcomes of Simple Rules for Monetary PolicySource: The Economic Outlook and Monetary Policy
Yellen's attraction to the optimal control policy comes out of her concern, shared by Chair Ben Bernanke, that persistently high unemployment will eventually lead to long-term structural unemployment. Note that Yellen sees little evidence that structural unemployment is currently a problem, and sees the current malaise as a cyclical one. However, again, she wants to be pro-active:
"[the] labor market slack at present is so large that even a very large and favorable forecast error would not change the conclusion that slack will likely remain substantial for quite some time…
…I am concerned that structural unemployment could increase over time if the labor market heals too slowly…the risk that continued high unemployment could eventually lead to more-persistent structural problems underscores the case for maintaining a highly accommodative stance of monetary policy."
In last week's speech in Boston, I believe Yellen got even more definitive about the downside risks in the economy (the housing market, fiscal policy, and the European sovereign debt crisis). Yellen cautioned that to-date economic forecasters have been overly optimistic about the strength of the recovery, and she worries that forecasts are once again too high. She also appeared more insistent on the need for further monetary action. She indicated that the balance of risks pointed toward a weaker economy and "…that a highly accommodative monetary policy will be needed for quite some time to help the economy mend."
Working in the Fed's favor are long-term inflation expectations that have remarkably stayed around 2% since 1998. This means the Fed has not worried much "…that higher energy and commodity prices would become ingrained in inflation and inflation expectations." In parallel, these anchored long-run expectations have apparently also helped to prevent a deflationary spiral from taking hold. This anchor further helps anchor Yellen's accommodative stance. I am expecting her analysis to hold stronger sway over her colleagues the longer economic data weakens in the U.S. and major economies across the globe.
Be careful out there!
Disclosure: I am long SDS.
Additional disclosure: In forex, I am net short the U.S. dollar