Yellen’s Speech Reinforces Our View that She Sees Three Hikes in 2017

In Yellen’s speech yesterday night at the Stanford, she again provided an optimistic assessment of the current state of the economy, progress made over recent years, and the economic outlook. She leaned against running the economy hot, supporting withdrawing accommodation gradually, but less gradually than the several most-dovish FOMC participants have advocated. She said the FOMC is not behind the curve, in large part because declines in the unemployment rate appear likely to have a very small impact on inflation.  She devoted a significant part of her speech to reviewing prescriptions from a number of policy rules,  making the point that no one knows which is most appropriate, which means it would be imprudent to tie policy to a single rule. This was a rebuttal to calls from Congress for monetary policy to be guided by a  specific policy rule. We saw the talk as consistent with our view that Yellen’s dot for 2017 is at the median of the December 2016 projections, consistent with three hikes this year. 

Yellen summarized the state of the macro economy today as close to full employment and price stability. ▪ Labor utilization is close to its longer-run normal level. The unemployment rate is near participants’  median estimate of the NAIRU, the U-6 rate “retraced nearly all of the steep run-up that occurred as a  result of the recession,” and some indicators even suggest the labor market is “a bit” tighter than before the financial crisis. 

▪ Regarding inflation, we are closing in on the 2% objective. Her defense of this was less compelling than it had been recently, as recent softness in core PCE inflation has brought the 12-month core inflation rate to just 1½%, only up ¼pp from the previous year and short of the 1¾% figure that she and other  FOMC participants have recently called the underlying rate.  

She defended the FOMC’s still-accommodative stance, arguing that the FOMC is not behind the curve. ▪ Wages have picked up only modestly, not consistent with an overheated labor market. ▪ The rise in core inflation reflects the waning effect of earlier movements in the dollar, which suggests that any impact of a tightening labor market has been very small. 

▪ She also noted that, because the effect of declines in the unemployment rate on inflation are very small,  there is only a very small risk of too-high inflation from the unemployment rate declining modestly below the NAIRU. 

On the other hand, she argued that “allowing the economy to run markedly and persistently ‘hot’ would be  risky and unwise.” 

▪ Yellen leaned again running the labor market hot, which we interpret as seeking to lower the unemployment rate below the NAIRU. 

▪ We view this as a change in her position. She had previously emphasized the potential benefits of doing so, which included unwinding adverse effects on the labor market that otherwise might become permanent and speeding the return to 2% inflation.

▪ Yesterday, she said doing so could cause inflation expectations to “begin ratcheting up, driving actual  inflation higher and making it harder to control.” 

▪ She added that a tight labor market and low interest rates could lead to undesirable increases in leverage and other financial imbalances. 

▪ Her final argument was that tightening too slowly might require the FOMC to raise rates rapidly, which could disrupt financial markets and push the economy into recession. 

Monetary policy must gradually shift toward a neutral stance, but there is uncertainty about what the neutral rate is today. 

▪ Participants estimate that the long-run real equilibrium funds rate (long-run r-star) is 1%—corresponding to a 3% nominal rate. 

▪ The Taylor rule assumes it is 2%, roughly the average before the Great Recession.

▪ FOMC participants have markedly reduced their estimates of the long-run r-star from above 2% to 1%.  Using the more recent estimates would reduce funds rate prescriptions from the Taylor rule by as much as 1¼pp. 

▪ But the level of r-star today—its short-run level—may be even lower (near zero) as a result of headwinds that have and continue to weigh on the economy. 

She noted that the FOMC regularly reviews a number of policy rules, and she compared the prescriptions from several rules to show how “simple policy rules can serve as useful benchmarks to help assess how monetary policy should be adjusted over time,” while warning that their prescriptions “must be interpreted carefully,” not followed mechanically. 

▪ First she considered versions of the Taylor rule with values of 2%, 1%, and 0% for r-star, all of which prescribe setting the funds rate above its current level. 

▪ The prescription of the Taylor rule with an r-star of 1% gets close to the median FOMC projection by the end of 2019, consistent with the idea that the FOMC sees r-star approaching its long-run projected value of 1% by that point. 

▪ She also presented a balanced-approach rule (with a 1% r-star), versions of which she has previously referenced. This rule prescribes a slightly faster pace of rate hikes than the Taylor Rule because it has a  higher coefficient on the unemployment gap. 

▪ The last rule she presented was a change rule that does not depend on an estimate of r-star. Rather, it prescribes moving the funds rate from its prevailing level by an amount that depends on the deviations from the NAIRU and the inflation objective. It calls for a much more gradual increase in the funds rate over the next few years, given participants’ macro projections. 

▪ The change rule is the only rule discussed that prescribes a funds rate path below the median FOMC  dots through 2019. The pace is so gradual because the currently “relatively modest” inflation and unemployment gaps call for a “fairly gradual” pace of hikes.

The Bottom Line 

▪ Yellen has an optimistic view of the state of the economy and the outlook, and a core consideration is that the unemployment rate and core inflation are close to their mandate-consistent levels.

▪ This suggests a withdrawal of accommodation and move toward a neutral r-star.

▪ Her focus on the short-run r-star and risk management considerations suggests a gradual return to a  neutral rate. 

▪ Her views appear consistent with our belief that her 2017 dot is at the median: three hikes in 2017.

▪ But participants’ views of appropriate policy, including hers, will evolve as fiscal policy changes become clearer. 

▪ She provided a compelling, comprehensive rebuttal to proposals in Congress that would require the  FOMC to designate certain policy rules as guides for monetary policy. 

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