Friday, April 1, 2016

The Fed: Thanks Again, Fairy Godmother!

Snow White didn’t have a fairy godmother. However, we do: Fed Chair Janet Yellen. In her speech this past Tuesday, she strongly suggested that she is in no rush to raise the federal funds rate again anytime soon. Apparently, she wants to see the snow whites of inflation’s eyes before doing so. Her speech before the Economic Club of New York was titled “The Outlook, Uncertainty, and Monetary Policy.”

By emphasizing uncertainty, she basically said that she (and her dovish allies on the FOMC) don’t have much confidence in their relatively upbeat outlook for the US economy. So it might be best to do nothing for a while. They clearly had more confidence when they hiked the federal funds rate at the end of last year. But then global financial markets tumbled at the start of this year after a couple of Fed officials said that four more rate hikes were likely by yearend. Apparently, the doves were traumatized by that and have decided to stay in their coop until there is more certainty. Consider the following:

(1) Volatile markets. At the start of her speech, Yellen said that “global economic and financial developments since December…“at times have included significant changes in oil prices, interest rates, and stock values.” She reiterated that “global developments have increased the risks associated with” the Fed’s outlook.

She continued to stress the market risks and uncertainties as follows: “Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year. For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar. Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting.”

(2) Risks to growth. Yellen is clearly concerned that by raising rates again, the Fed could destabilize the global economy and financial markets, which certainly would have an adverse impact on the US. She mentioned that while China is certainly slowing, there is much uncertainty about the pace of the slowdown. She didn’t say so directly, but she implied that Fed actions could destabilize China’s financial markets and exchange rate.

Rather than focus on the recent rebound in oil prices, Yellen chose to say that if they start falling again, that could renew the risk of an adverse “financial tipping point” for some oil-producing countries and companies.

(3) Risks of disinflation. Yellen also was extremely dovish about the inflation situation. She noted that the PCED inflation rate was 1.0% y/y through February and that the core rate was 1.7%, up from a recent low of 1.3% during October. In other words, the core rate is getting close to the Fed’s 2.0% target. Yet she chose to minimize this development as follows: “But it is too early to tell if this recent faster pace will prove durable. Even when measured on a 12-month basis, core inflation can vary substantially from quarter to quarter and earlier dollar appreciation is still expected to weigh on consumer prices in the coming months.”

Consequently, she expects inflation will remain below 2.0% this year, though it should be up there in 2017 and 2018. She continued to accentuate the risks of lower inflation, saying: “The inflation outlook has also become somewhat more uncertain since the turn of the year, in part for reasons related to risks to the outlook for economic growth. To the extent that recent financial market turbulence signals an increased chance of a further slowing of growth abroad, oil prices could resume falling, and the dollar could start rising again.”

(4) Uncertainty begets caution. The conclusion was obvious: The Fed should do no more harm as it had at the start of the year. Yellen put it this way: “Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”

I think this all adds up to another year like last year of either none-and-done or one-and-done for Fed rate hikes. I am leaning toward the first choice. There could be more global uncertainty this summer if Brexit happens. In early November, there could be more domestic uncertainty if Donald Trump happens.

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