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Yellen takes a “stitch in time” approach even while taking a robust view on the economy,..

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Mr Dhananjay Sinha

Head of Research and strategist.

22 Sep 2016

Jannet Yellen today again ducked the chance of raising the Fed rate even while providing copious hints that FOMC members thought it was appropriate for them to increase rate immediately. There were three prominent descents. 

This decision to keep the target rate steady was driven by a precautious view towards sustaining the strength in the labor market. 

Importantly, Yellen’s described the gains in the labor market as very solid which has been fuelling strong personal consumption demand. The fact the unemployment rate has remained steady at 4.9% during the current year despite the recent unanticipated rise of the labor participation rate, is seen as a very healthy sign. It indicates that the pace of employment creation, averaging at 180k is strong enough to absorb the residual slack in the labor market. 

The reason the Fed refrained one more time is pegged to two important assessments:

a) Persistence of residual slack in the labor market, created by recent unanticipated gains in labor force participation rate following sustained decline since late 1990s

b) Even while taking a robust view on labor market conditions, the core PCE inflation rate at 1.5% is still below the targeted 2%. This in the face of residual slack in labor market somewhat diminished the urgency to hike rate. 

By indicating that the current Fed rate was only marginally accommodative, Yellen was quick to emphasise that Fed was not falling behind the curve by being backward looking. It would be easy for the Fed to respond by hiking fed rate if there are signs of over-heating. Median projection for Fed rate is now pegged at 1.1% for 2017 and 1.9% by end of 2018. Long term neutral rate at 2.9% is now seen somewhat lower than 3% in the June policy . 

Strengthening of labor market, gains in wage growth and strong personal consumption are boosting the domestic factors behind inflation but core PCE inflation at 1.5% is still lower than Fed’s 2% target. Disinflationary impulses still emanate from the lingering impact of earlier decline in energy and crude oil prices. Fed believes that this is only a transitory phenomenon—as these disinflationary factors recede and labor market continue to be on a recovery path the 2% inflation target is expected to be achieved. 

While downplaying the potential risk of creating financial instability due to low Fed rate, Yellen probably for the first time acknowledged that there are pockets of bubble in the commercial real estate markets, which has recently attracted Fed’s attention. For the moment, Fed believes that regulatory responses will help tame this bubble. In addition, quite like her Jackson Hole speech last month, Yellen reiterated the need for fiscal impulses to revive growth rather than merely relying on ultra-loose monetary policy. 

Outlook:

Overall, I would characterize Yellen’s statement as somewhat hawkish with rising level of confidence over her recent speeches. The fact that she was emphatic about the consensus emerging in favour of an immediate hike is an important communication for the markets, which carries forward the scope for rate hike later this year. Having said that the hide and seek game that the Fed has been playing of shifting the goal post since the Dec’15 hike has been immensely frustrating. And today’s mixed communication clearly hint at a deeply divided house. Nevertheless, Yellen’s speech today and BoJ’s statement yesterday of targeting yield curve steepening, are clear indicators that declining efficacy of over-accommodative monetary policy is sowing seeds for ending of quantitative easing and low interest rate era. This would mark the advent of fiscal stimulus across the world, including the US, Europe & Japan. 

Notwithstanding that a “no Fed rate hike” outcome was unsurprising, US equities rose following today’s announcement while the European market retain the gains of 0.5%. 10 year US treasury yield also eased somewhat to 1.66% from pre-FOMC meeting high of 1.7% and USD also gave away some gains (EUR at 1.12, up 0.3%). Crude oil prices surged over 3% at USD 47/bbl. 

The fact that recent status quo announcement by major central banks have failed to create sustainable rallies in equities, reflects diminishing response of markets to monetary policy announcements. In the meanwhile marginal tapering QEs, a flavour towards fiscal stimulus and bottoming out of inflation are gradually pushing up treasury yields