As you know, last week the Federal Open Market Committee (FOMC) changed its forward guidance pertaining to the federal funds rate.
This is how Yellen began her speech to a research conference sponsored by the Federal Reserve Bank of San Francisco on March 27.
With continued improvement in economic conditions, an increase in the target range for that rate may well be warranted later this year.
The speech titled Normalizing Monetary Policy: Prospects and Perspectives, was primarily used as a way to provide talking points around the Fed's change in forward guidance.
An Aggressive Change In Forward Guidance
In Yellen's previous statement it seemed the FOMC was looking for improvements in 1) the labor market and 2) consumer confidence before raising rates. Specific data points and thresholds were also provided like a drop in the unemployment rate from 5.0 to 5.2 percent. This was the initial requirement for an increase in rates -- specific data points with thresholds.
In her last speech, however, Yellen changes and takes on a more aggressive stance. Here's an excerpt:
...we need to keep in mind the well-established fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.
In other words, we should increase rates so that they won't be low in case we need to decrease them again? I feel like I'm in a cartoon. The only scenario in which Yellen won't raise rates in June is if labor and consumer confidence indicators were to materially weaken.
...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.
How did we go from waiting for certain data driven levels of unemployment to hoping that current levels don't fall? Yellen also referenced John Taylor and several interest rate models used to support a case that the market equilibrium rate of zero is actually due to a host of headwinds that should ease later on this year. These "headwinds" include (I can't make this stuff up):
- tighter underwriting standards
- restricted access to some forms of credit;
- high household debt
- contractionary fiscal policy
- uncertainty about the economic outlook
- households reluctant to buy houses, cars, and other discretionary goods.
Basically, she's saying the real price of money fell below 0 percent because there was a recession. She uses this to support the argument that the underlying economy may be weak but is on an uptrend and will be back to normal once these headwinds abate. As a result the equilibrium rate will also continue to rise and is most likely already past the current level. "At present," she says,
the equilibrium real federal funds rate, which by some estimates is currently close to zero, appears to be well below the longer-run normal levels assessed by the FOMC. The median SEP estimate of this longer-run normal rate--that is, the long-run projection of the nominal funds rate less 2 percent inflation--stood at 1-3/4 percent in the FOMC's recent projections.
The argument is used to buoy not just one, but two rate hikes.
Provided that inflation shows clear signs over time of moving up toward 2 percent in the context of continuing progress toward maximum employment, I therefore expect that a further tightening in monetary policy after the first increase in the federal funds rate will be warranted.
What I wonder about the most is how the Fed plans on maintaining control. There was little talk about this. They must be feeling a bit like the semi-impotent lover -- they saved the economy from a host of tightening fiscal policy initiatives only to find that their ability to "raise rates" could fall short of current needs. Perhaps this explains the change in policy away from data driven decisions and towards any and all arguments that can be made for raising rates.
I'm going to change the original forecast. If labor indicators and inflation rates decline significantly, the original forecast holds and rates won't be raised until the end of the year. However, if labor rates remain at current levels or continue to improve expect to see rates increase as early as June.
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