Last week’s data did not affect our views about the outlook for monetary policy. But the financial repercussions of Brexit did. This week we will make a preliminary judgment about how much the worsening of financial conditions, if sustained, might affect our forecast for growth and inflation. Given that the effect will be to slow growth and lower inflation as well as to further increase uncertainty, the risk-management orientation of the FOMC in its current state of wait and see suggests that there will be a longer wait. We therefore moved September into the “possible but not probable” category and see December as the more likely time for the first rate hike. But the uncertainty about financial conditions spills over into even greater uncertainty about our call, especially given that a lot could happen by December.
The communications last week came before the final results of the Brexit referendum, so we will want to see this week’s speeches to see how FOMC participants judge the U.K. vote would affect their forecasts and whether this is just another of many developments calling for risk management and a longer wait.
Yellen’s semiannual testimony was the highlight and she unexpectedly offered some surprising new language about the preconditions for resuming normalization. Previously she had said that the FOMC was awaiting data to see if it would verify their expectations. Last week she said they were waiting see whether their expectations would be met. As we like to say with regard to official communications, every word counts.
Interestingly, and, I believe, new, both Kaplan and Powell said they were monitoring the yield curve. Powell noted that the yield curve has “come down really a lot this year,” which he attributed in part to investors pricing in downside risks. Kaplan also said he was monitoring the slope of the yield curve, as well as other measures of tightness in financial conditions. In Jonathan Wright’s commentary on the yield curve, he noted that a narrowing of the term spread, especially an inversion of the yield curve, can be a harbinger of recession, but that other considerations, specifically the level of the funds rate and the term premium, should also be taken into account.