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02 10 2016 | by Victor Xing | Central Banks

February 2016 Monetary Policy Report: “watchful waiting”

Summary of the February 2016 Monetary Policy Report

Federal Reserve Chair Yellen testified at the semi-annual Monetary Policy Report on behalf of the FOMC on February 10th and 11th.  Even though Governor Brainard, President Dudley and Vice Chair Fischer were not present at the Congressional hearings, their policy views were reflected in Yellen’s written testimonies and Q&A comments.

Investors were expecting a dovish nod from Chair Yellen in-light of recent events, and she delivered it by highlighting the tightening of financial conditions (a point previously outlined by New York Fed President Dudley) against the macro backdrop of China uncertainties, dollar strength, and persistent weakness in oil prices.  Nevertheless, speculations of rate cut were met with disappointment, and Q&A comments raised uncertainties on Federal Reserve’s near-term readiness to implement negative rate policies similar to those enacted by the ECB and BOJ, a point previously elaborated by Vice Chair Fischer in January.

As a whole, the Committee is adopting a cautious tone that echoed Governor Brainard’s comment on “watchful waiting,” although the Committee does not appear to be rushing for a rate cut unless economic and financial conditions deteriorate further to warrant such move.  Finally, negative interest rates is theoretically possible, but policymakers still need to overcome short-term “transitional problems” within the U.S. financial system and identify unknown risk factors.

Financial Conditions

Chair Yellen highlighted recent tightening of financial conditions in her testimony, which have “become less supportive of growth.”  Nevertheless, she added that negative impacts on labor market and economic outlook are conditional to a more persistent tightness in financial conditions (see highlight below).

Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset. Still, ongoing employment gains and faster wage growth should support the growth of real incomes and therefore consumer spending, and global economic growth should pick up over time, supported by highly accommodative monetary policies abroad. Against this backdrop, the Committee expects that with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in coming years and that labor market indicators will continue to strengthen.

Next, Chair Yellen focused on foreign risk factors (China’s soft patch and FX volatility).  It is also worth mentioning that she recognized the negative feedback loop connecting weak growth sentiment and commodity weakness, as well as impacts to financial conditions if further downside risks materialize.

As is always the case, the economic outlook is uncertain. Foreign economic developments, in particular, pose risks to U.S. economic growth. Most notably, although recent economic indicators do not suggest a sharp slowdown in Chinese growth, declines in the foreign exchange value of the renminbi have intensified uncertainty about China’s exchange rate policy and the prospects for its economy. This uncertainty led to increased volatility in global financial markets and, against the background of persistent weakness abroad, exacerbated concerns about the outlook for global growth. These growth concerns, along with strong supply conditions and high inventories, contributed to the recent fall in the prices of oil and other commodities. In turn, low commodity prices could trigger financial stresses in commodity-exporting economies, particularly in vulnerable emerging market economies, and for commodity-producing firms in many countries. Should any of these downside risks materialize, foreign activity and demand for U.S. exports could weaken and financial market conditions could tighten further.

Indeed, FCI has tightened notably amid market volatility.  Major components of the Goldman Sachs Financial Conditions Index are as follows:

  • Short-term bond yield
  • Long-term corporate yield (sum of the 10-year swap rate and the 10-year credit default swap spread)
  • Exchange rate
  • Stock market variable
Monetary Policy Report - GS Financial Conditions Index
GS Financial Conditions Index

Chair Yellen’s testimony shared similar elements with New York Fed President Dudley’s February 3rd speech, in which he highlighted his concerns on the FCI tightening:

Financial conditions have tightened considerably in the weeks since the U.S. Federal Reserve raised interest rates and monetary policy makers will have to take that into consideration should that phenomenon persist, a top Fed official said on Wednesday.

In addition, the weakening outlook for the global economy and any further strengthening of the dollar could have “significant consequences” for the health of the U.S. economy, William Dudley, president of the Federal Reserve Bank of New York, told MNI in an interview.

“One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting,” said Dudley, a permanent voter on the Federal Open Market Committee, the Fed’s monetary policy arm.

“So if those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision,” he said.

President Dudley’s work on financial conditions elevated the importance of GS FCI.  He co-authored the index with his successor, current GS chief economist Jan Hatzius.

Watchful Waiting

The cautious tone from the FED Chair echoed Governor Brainard’s now-famous “watchful waiting” policy comment on February 3rd:

Federal Reserve governor Lael Brainard thinks there are strong reasons to go slowly on further interest-rate increases.

That opinion is an important one: The 54-year-old economist is emerging as a significant influence at an uncertain time for monetary policy and market tumult, and her arguments have traction with the Fed’s leadership.

Her concern is that stresses in emerging markets including China and slow growth in developed economies could spill over to the U.S. “This translates into weaker exports, business investment and manufacturing in the United States, slower progress on hitting the inflation target, and financial tightening through the exchange rate and rising risk spreads on financial assets,” Ms. Brainard said Monday in response to questions from The Wall Street Journal.

“Recent developments reinforce the case for watchful waiting,” she said.

Indeed, Chair Yellen did not signal the Committee is pursuing a policy to undo its December rates decision, and the current policy stance places emphasis on keeping options open but proceed cautiously.  During the testimony, Chair Yellen re-emphasized that the FOMC is “closely” and “carefully” monitoring economic and financial conditions, as well as progress toward its 2% price stability mandate.  As for rate cut:

I do not expect the FOMC will soon be in the situation where it’s necessary to cut rates.

There is always some chance of a recession in any year, but the evidence suggests expansions don’t die of old age.

Negative interest rates

The discussion over negative interest rate occurred during the Q&A, which Rep. Patrick McHenry (R-N.C.) asked Chair Yellen whether negative rates is legal.  Yellen provided the following response:

That remains a question we still would need to investigate more thoroughly.  I am not aware of anything that would prevent us from doing it, but I’m saying that we have not fully investigated the legal issues. That still needs to be done.

Setting legal issues aside, Chair Yellen also highlighted that the Federal Reserve is open to consider negative interest rates as a policy tool:

We had previously considered them and decided that they would not work well to foster accommodation back in 2010

In light of the experience of European countries and others that have gone to negative rates, we’re taking a look at them again because we would want to be prepared in the event that we needed to add accommodation

Barriers to implementing negative rates remain in place, and the FED Chair acknowledged that it has not yet been determined whether “plumbing of the payment system in the U.S. could handle [negative interest rates].”

Some implementation hurdles of negative interest rates was noted by Vice Chair Fischer in his January 3rd speech:

Could negative interest rates be a policy response that the Federal Reserve could choose to employ in a future crisis? One possible concern with a strategy of this sort in the United States is the potential for destabilizing effects in money markets. For example, various observers have noted that negative rates could lead to scenarios in which money funds “break the buck” or simply shut down, either of which could generate strains in money markets. Another concern is whether the complex and interconnected infrastructure supporting securities transactions in the U.S. financial system could readily adapt to a world of negative interest rates. For example, similar to the types of issues addressed ahead of the year 2000, there could well be automated systems that simply are not coded properly at present to process transactions based on instruments with negative rates. All of these are, of course, transitional problems, but they might be sufficient to make a move to negative rates difficult to implement on short notice.


The February 2016 Monetary Policy Report provided a valuable update on the “inner core” of FOMC thinking, and it appears that President Dudley and Governor Brainard remain close to the FED Chair in their policy views (which also suggest that Governor Tarullo and Powell are closely behind, given their past track record).  Chair Yellen left her options open, and she may be reliving memories of 2Q and 3Q 2015, when the FOMC pushed out rate hike expectations amid market volatility and foreign growth concerns.

Next article02 09 2016 | by Victor Xing | Economics

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