Further Tightening on Track

Yellen’s comments today have not led us to raise our estimated probability of a March hike, which we still see as a one-third probability. And we still anticipate three hikes over the course of this year. But the tone of Yellen’s prepared testimony struck us as slightly more hawkish than we expected. 

Where we saw a slightly more hawkish tilt was her upbeat description of the labor market and her hawkish reiteration of the risks of monetary policy waiting too long to remove accommodation. 

Compared with her previous comments on labor market conditions, today’s remarks projected slightly more optimism. An additional piece of evidence she cited for improving labor utilization was wage growth, which  “has picked up relative to its pace of a few years ago, a further indication that the job market is tightening.”  That observation was notable, given the recently observed disappointing advance in average hourly earnings and the subdued readings from the employment cost index. (See Improving Labor Market Without Wage  Pressure.) Indeed, she revealed in response to a question that the Fed’s inflation projections were consistent  with “somewhat faster wage growth than we’re seeing.” But by mentioning the pickup in wage growth,  they are signaling greater confidence in their assessment that the labor market is tightening. 

She was also upbeat today on the prospects for economic growth, citing continued healthy increases in consumer spending and recent improvements in business sentiment and investment. 

Two sentences in her prepared remarks today stood out as signaling a slightly more hawkish stance. 

“Waiting too long to remove accommodation would be unwise.” While she has often warned of the risks of waiting too long to complete rate normalization, today’s mention feels particularly strong as it was not balanced against a usual warning of the asymmetric risks of returning to the zero lower bound following a  too-aggressive rate-hike campaign. She echoed this line of thought in an answer to a senator’s question:  The Fed must “to be careful not to allow conditions to become so tight that we push inflation” above its objective. 

A second sentence also made her remarks sound more hawkish: “At our upcoming meetings, the  Committee will evaluate whether employment and inflation are continuing to evolve in line with these  expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”  Such a preview sounds quite strong given the usual guardedness of her comments. Of course, she also  sounded her usual caveat that “monetary policy is not on a preset course.” 

However, her comments today do not make us see a March hike as more likely than before. One reason is the uncertain fiscal environment. She warned that “it is too early to know what policy changes will be put  in place or how their economic effects will unfold.” 

Therefore, while we suspect she still sees three hikes for 2017 as her baseline, we don’t think that those hikes will begin until June.

Her characterization of the outlook for growth, employment, and inflation seems to be little changed from her  December press briefing statement and January speech. Both today and in recent remarks, she expected the economy to grow at a “moderate” pace, labor market conditions to strengthen “somewhat further,” and inflation to rise to 2 percent. 

As we expected, she remained tight-lipped in her prepared remarks on changes to reinvestment policy,  although in the Q&A she reiterated the FOMC’s intent to reach a “substantially smaller” balance sheet in an  “orderly and predictable way.” She also noted that she did not see the balance sheet as an “active tool”  and that the FOMC does not plan to rely on balance sheet policy “frequently” in the future. She observed  that ending reinvestments would result in “some tightening of financial conditions.” 

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