Mr. Market Nips at Yellen’s Heels
It’s a good thing Janet Yellen already knows where to find the women’s room at the Federal Reserve Board, because her first year as chairman could offer some interesting challenges.
No, I’m not talking about winding down the Fed’s asset-purchase program or assessing the costs and benefits of using a blunt instrument -- the federal funds rate -- to address long-term unemployment. I’m talking about something else.
If -- and it’s still a big if -- the recent economic numbers are indicative of a trend, Yellen is going to face an early test in the area of communications, something she knows a lot about. Specifically, the Fed’s forward guidance on interest rates, which worked pretty well with the economy growing at 2 percent and inflation falling, could come under attack.
The latest economic reports on employment, housing, manufacturers’ orders, industrial production, exports, and consumer spending and confidence all showed surprising strength. Economists dutifully raised their economic forecasts for gross domestic product growth in 2014 -- to 3.5 percent from 3 percent, in some cases -- in the hopes that those predictions would come to fruition this year. (There’s nothing like hindsight to make economists more upbeat about the future.)
Yellen was tapped by Fed Chairman Ben Bernanke in 2010 to head a committee to determine the most effective way for the Fed to transmit its intentions to the markets. She has been a strong advocate of increased transparency and forward guidance, including announcing specific thresholds for unemployment and inflation. As she said in a speech to a gathering of journalists in April 2013: “The effects of monetary policy depend critically on the public getting the message about what policy will do months or years in the future.”
But policy makers don’t know what policy will do months or years in the future. And that’s why forward guidance can never be a reliable policy tool: It’s only as good as the Fed’s visibility. It takes roughly five to nine months for the Fed to determine if a change in the data is significant enough to incorporate into its Summary of Economic Projections (SEP), released four times a year, according to a study by Citigroup Inc. economist Benjamin Mandel and research associate Robert Sockin.
So far, there has been little movement in fed funds futures contracts. The median forecast for the funds rate at the end of 2015 is 0.75 percent, according to the Fed’s Dec. 18 SEP. The December 2015 fed funds futures contract is trading at an implied yield of 0.835 percent. The Fed’s wish is the market’s command.
That could change, and change quickly, if the economy ratifies optimistic GDP expectations. Mandel and Sockin use a modified Taylor Rule to show “how much distance there is between the normal behavior of the funds rate under the rule and what the Fed is saying” about the trajectory, Mandel said in an interview. (The Taylor Rule describes the appropriate path for the funds rate based on the difference between actual and potential GDP growth and actual and target inflation.) The gap starts out small -- 1.4 percentage points in 2014 -- and widens to 2 percentage points through 2016. It’s even at odds with Yellen’s optimal control model, which implies that the funds rate stays lower for longer but rises more quickly after that, Mandel said.
Other measures point to an even wider divergence between what is normal and what the Fed is projecting. Using the Fed’s long-run projections for full employment (an unemployment rate of 5.2 percent to 6 percent) and the neutral funds rate (4 percent), policy makers expect the benchmark rate to be almost 400 basis points below the appropriate level at a time when the economy is approaching full employment. That doesn’t sound like a stable situation.
All this presumes that inflation remains well-behaved and inflation expectations well-anchored. If inflation starts to accelerate in tandem with stronger growth, Yellen will have to shout her assurances of “zero forever.” And even then, the market may choose to ignore her.
“If the economy grows according to consensus, it is very likely that the debate inside the FOMC would become about when to raise rates, not about how long to keep them at zero,” said Roberto Perli, a managing director at Cornerstone Macro LP in Washington. At that point, “market expectations of rate hikes would likely be brought forward regardless of what the Fed will say.”
I read somewhere that Bernanke’s inaugural gift to Yellen was the decision to start tapering its asset purchases before his departure on Jan. 31. At minimum, there is a sense of poetic justice: The Lord giveth and the Lord taketh away.
If the optimists are right -- and I hope they are because this limping along at 2 percent is getting old -- that gift could appreciate in value. The last thing Yellen will need is a still-expanding balance sheet if and when Mr. Market starts nipping at her heels.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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