Greater Gradualism For The Greater Good

by: Kristina Hooper

The biggest news of last week

The biggest news of last week was not the March jobs report nor the most recent US presidential race developments - it was Federal Reserve Chair Janet Yellen's speech last Tuesday to the Economic Club of New York. In it, she extolled the virtues of a more gradual rate hike path given current economic and financial conditions, which have become somewhat "less favorable" since December, when the Federal Open Market Committee (FOMC) decided to embark on an initial rate hike.

Yellen's expectation of greater gradualism in rate hikes allayed fears stoked just the previous week by other FOMC members that the Fed would raise rates soon. Those previous speeches - particularly from St. Louis Fed President James Bullard - had sent stocks downward and pushed the yield on the 10-year Treasury upward. But then came Chair Yellen's speech, and stocks moved up while Treasury yields moved down.

Beware the talking Fed

In a commentary last year we warned investors to "beware the talking Fed" - and there was no better example of that than what we saw in the past two weeks. Market participants were whipsawed from one view of the trajectory of rate hikes to another, thanks to the words of different Fed members. However, we need to realize that Yellen's words are the most important-the ones we must pay most attention to.

In last week's speech, Yellen recognized that, on balance, conditions have deteriorated since December. She presented her belief that at this juncture there are asymmetric risks to monetary policy and that it is therefore more advisable to keep rates lower for longer, with the Fed remaining behind the curve to support economic growth.

It appears the Fed will err on the side of being more accommodative rather than less. Of course, Yellen also provided caveats to this view, saying that the path is not "set in stone" but will instead evolve as needed. She also lauded market participants for recognizing the data dependency of the Fed's monetary policy and automatically adjusting expectations of rate hikes based on economic data.

Inflation: seeking just enough

Yellen devoted significant air time in her speech to the topic of inflation. But she downplayed the recent increase in core PCE inflation, and instead worried more about the lowering of longer-term inflation expectations. It seems that Yellen's recommended course of action - a more gradual increase in rates - could open the door to higher inflation. And Yellen did recognize that at least a small risk of higher inflation exists when she said,

despite the declines in some indicators of expected inflation, we also need to consider the opposite risk that we are underestimating the speed at which inflation will return to our 2% objective.

A more dovish Yellen will likely lead to a weaker US dollar which benefits most commodities and emerging markets. However, the dovish tone also implies lower US economic growth that, if sustained, could lead to lower or falling earnings growth. However, Yellen acknowledged "economic growth here and abroad could turn out to be stronger than expected, and, as the past few weeks have demonstrated, oil prices can rise as well as fall." She finished her speech with the admission that

economists' understanding of inflation is far from perfect, and it would not be all that surprising if inflation was to rise more quickly than expected over the next several years.

Signs of improvement in the US economy

Investors need to pay attention to the risk, however small, of higher inflation. While the Atlanta Fed just lowered US GDP growth expectations for the first quarter substantially, we are seeing many signs of improvement in the US economy. Consider that one of the greatest areas of weakness for the US economy, the manufacturing sector, is showing signs of improvement.

For example, the ISM Manufacturing Index moved back into expansion territory in the month of March. Of particular note is that new orders rose to a 15-month high. And while global demand may be less than robust and create a headwind for manufacturing, the dollar may actually provide something of a tailwind.

In fact, the ICE Dollar Index, which measures the US dollar against a basket of six currencies, fell more than 4% in the first three months of the year, its worst quarterly performance since 2010. What's more, despite presidential election uncertainty and fears of more terrorist attacks, recent consumer sentiment readings have been solid. And last Friday we received another mostly positive jobs report that included some improvement in wage growth.

Hedging against inflation

So while Yellen may be pursuing greater gradualism in Fed rate hikes in order to support the US economy, we need to recognize that such a stance increases the risk of higher inflation. As such, investors need to ensure they have adequate exposure to asset classes that have historically served as a hedge for inflation, such as Treasury inflation protected securities (TIPS), dividend-paying stocks and gold. While investors aren't that concerned about inflation right now, they should be.