Within inflation picking up again, Janet Yellen's speech before the Economic Club of New York on March 29 was highly anticipated. Entitled “The Outlook, Uncertainty and Monetary Policy”, it certainly had what it takes to capture attention. Ms. Yellen's accommodative stance was not a surprise: indeed, she delivered the same message after the FOMC on March 16. However, the Fed's “reaction function” was outlined a little more clearly. How does the Fed manage risks? How would it respond if these risks materialised? How is uncertainty affecting its decisions? All of these questions, given no clear answer since December 2015, were addressed in Ms. Yellen's speech.
Janet Yellen is bringing back the good old-fashioned risk management approach. This approach - made popular in his time by Alan Greenspan - consists in some cases of taking risks more into consideration (in order to guard against them) than fundamentals. Under this approach, some risks - especially (but not only) those seen as potentially systemic - can influence monetary policy, irrespective of the usual fundamentals (growth, employment, inflation). The usual rules of monetary policy (such as the Taylor Rule) are temporarily placed on the back burner.
With interest rates near the zero lower bound, there is an asymmetry that may prove harmful to the Fed's credibility 1. Indeed, if the economic environment improves significantly, the Fed can always raise its rates to keep inflation expectations under control; conversely, if the outlook deteriorates, it holds very little leeway for further rate cuts. While the “asymmetric argument” has its merits, Ms. Yellen nevertheless put its scope into perspective. After all, the Fed can always ease monetary conditions if it needs to by lowering longterm interest rates. To this end, Janet Yellen indicated that the Fed can modify its balance sheet in two ways:
A year ago, the asymmetric risks associated with the zero lower bound were used to explain why the Fed should not raise its rates. Today, Ms. Yellen is highlighting this approach to justify a cautious and gradual approach, one that is more gradual than dictated by responses based solely on fundamentals. The strength of the dollar and risks of flagging global growth are explicitly mentioned by Janet Yellen in her speech.
How can the intensity of risks ultimately be measured? The movements in the dollar, oil, economic data and the financial markets in general offer some indications. In our view, however, the financial stress indices best capture risk perception by market participants. When these indices exceed a given threshold, the probability of a systemic accident increases dramatically. In February, the Cleveland Fed's financial stress index raised the alarm when it reached levels seen only three times in the last 25 years: in 1998 with the collapse of the LTCM fund (post-Russian default), in 2007-2008, and in 2011 with the spreading of the Greek crisis. Of these three episodes, two were clearly false alarms (1998 and 2011). In all cases, though, the Fed's policy changed and helped ease stress; in particular, the Fed cut its rates in 1998 and launched Operation Twist in 2011 (extended in 2012). The current level of the Cleveland financial stress index has probably the Fed’s attention.
It can be argued that in a way, the Fed already eased its monetary policy stance on March 16, when it lowered its own forecasts on fed funds rate increases. Janet Yellen just confirmed this change on March 29, offering more clarifications on the reasons for the Fed's gradual approach. Neither the dollar (down) nor the equity market (up) was wrong on that score.
Ultimately, this means it will take more than a modest rise in inflation for the Fed to change tacks and step up its rate hike timetable. There are at least four reasons for this:
At the end of the day, we maintain our scenario: we do not expect the Fed to hike rates more than twice this year. As long as there is no significant upturn in core inflation by the summer, the Fed could wait until after the November presidential elections and raise its rates only once in December.
1 Janet Yellen is again referring to an approach formalised in a paper written a year ago by the members of the Chicago Fed (“Risk management for monetary policy near the zero lower bound”, Evans, Fisher, Gourio and Krane, BPEA Conference Draft, March 2015).
2 By not mentioning the possibility of taking interest rates into negative territory, Janet Yellen implicitly reveals that the Fed has negated this option (for now).
3 The neutral real rate is defined in Yellen’s speech as “the level of the real fed funds rate that would be neither expansionary nor contractionary if the economy was operating near its potential”.
With rates close to the zero lower bound, risks are perceived as asymmetric
In a way, it can be argued that the Fed already eased its policy stance with its communication