Yellen Leaves Markets With the Wrong Impression

It would be a mistake to interpret the Fed Chair's comments as a dovish turn that puts in doubt the expected policy path.

Janet Yellen sends mixed signals.

Photographer: Zach Gibson

Federal Reserve Chair Janet Yellen’s prepared testimony for her semi-annual report to Congress made clear that central bankers are struggling to understand the recent downward trend in inflation. Still, it is important to remember that the path of monetary policy depends not just on inflation, but also on unemployment. Yellen knows this, and it would be a mistake to interpret her comments as a dovish turn that puts in doubt the Fed’s expected policy path for the remainder of this year and in 2018.

Here's the key passage in Yellen's prepared testimony where she highlighted the inflation issue in the context of the Fed's forecasts:

Of course, considerable uncertainty always attends the economic outlook. There is, for example, uncertainty about when -- and how much -- inflation will respond to tightening resource utilization.

The Fed currently attributes low inflation readings to transitory factors. Yellen reiterated this point in the prepared testimony as well as in the question-and-answer portion of the hearing, again citing a drop in cell phone prices as a particular factor. As those transitory issues wane, the Fed anticipates that low unemployment will push inflation back to its 2 percent target. Traditionalists at the Fed, including Yellen, believe that if policy makers do not tighten pre-emptively in this environment, unemployment will undershoot its natural rate, pushing inflation above target.

I suspect Yellen’s experience over the last two cycles will for the time being discourage her and her fellow policy makers from changing their forecast for one more rate hike plus balance sheet reduction this year and three rate increases next year. This is Yellen's third expansion at the big table, and the lesson she learned from the last two is that the longer the Fed waits to tighten, the more likely that a recession will be the end result.

That said, Yellen will not ignore low inflation forever. The longer it lasts, the more the shortfall looks more persistent than transitory. All else equal, this would work its way into the inflation forecast, requiring a lower path of rate hikes to meet the Fed’s target.

But all else is never really equal. In addition to inflation, the Fed’s reaction function includes unemployment. That adds an additional complication for policy makers. The Fed’s current policy baseline is that we have already seen the low for unemployment this year with May’s 4.3 percent reading. My assumption is that if anything, this forecast is too pessimistic and that the Fed’s growth forecasts are consistent with further declines.

Putting this all together, I see four likely potential policy paths. In general terms:

  • Inflation rebounds while unemployment holds steady. This is essentially the Fed’s baseline forecast, implying one more hike this year and three more next year.
  • Inflation remains persistently low and the unemployment rate holds steady. Under this combination, the Fed likely passes on the third rate hike for this year and lowers the projections for 2018.
  • Inflation rebounds while unemployment falls further. A rebound in inflation would revive the Fed’s faith in their current estimate of the natural rate of unemployment. That coupled with a further decrease in unemployment would likely encourage the Fed to increase its projected rate path for 2018.
  • Inflation remains persistently low while the unemployment rate falls further. In this scenario, the Fed remains uncertain about the estimate of the natural rate of unemployment. This is probably the most difficult outcome for policy makers. But if unemployment falls below 4 percent and looks to be headed lower, they will have a hard time not continuing the current path even if inflation remains below target.

I tend to think the Fed will more likely than not face one of the latter two scenarios.

Note that I excluded the possibility of unemployment -- actual or forecasted -- suddenly rising. First, I don’t think it is likely. Second, assuming this is the result of widespread economic weakness, the policy response is obvious -- loosen, not tighten. I also assume that in any of the situations, the Fed will begin balance sheet reduction by the September meeting. That process appears to be well underway.

Although the focus is currently on inflation, we shouldn’t ignore the other part of the part of the Fed’s mandate. Unemployment as well as inflation will play into the Fed’s policy decision.

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