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03 29 2016 | by Victor Xing | Central Banks

Chair Yellen and Board of Governors’ reaction function

Chair Yellen’s speech at a glance

Federal Reserve Chair Yellen used her latest speech at the Economic Club of New York to communicate a policy reaction function likely shared by her and a number of senior Fed policymakers – Governor Brainard, President Dudley, as well as Governor Tarullo and Powell.  Similar to the dovish March FOMC press conference, the Fed Chair’s cautious policy stance over asymmetric inflation risk, global growth uncertainty, as well as skepticism toward the nascent rise in core PCE inflation represents yet another nod to Governor Brainard’s call for “watchful waiting:”

Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower

Also reflecting on financial markets’ crucial role in transmitting monetary policy to the real economy via financial conditions, the Fed Chair acknowledged market participants’ dismissal of December FOMC’s “dot plot” and their contribution in pushing down rates beyond near-term maturity instruments.  This culminated to the dovish March FOMC, when policymakers’ projections converged toward market expectations.

Yellen
Price of FV (5 year Treasury futures) in blue rallied as yields declined amid equity underperformance (S&P e-mini in gold), thus provided cheaper borrowing cost to offset gloomier investor sentiments – the large spike up on March 16th was due to the dovish surprise at the March FOMC

In return, financial markets noted Yellen’s cautiousness relative to her more optimistic FOMC colleagues (which markets also reacted to, albeit far less vigorously in comparison): President Lockhart recently commented that April rate hike is “on the table,” President Williams expressed a more sanguine view on inflation, and Cleveland Fed President Mester as well as Kansas City Fed President George maintained their warnings on upside inflation risk.

Amid uncertainties, Chair Yellen reacted to rising hawkish expectations by actively pushing out the timing of next rate hike via policy communication.  Focusing on the Fed Chair over Federal Reserve Bank Presidents, market participants priced in slightly less than one hike for the year of 2016 (this figure briefly fell to roughly zero at the peak of recent oil rout before rising again on firmer inflation data and a rebound in oil prices).

Yellen
Fed funds futures showing slightly less than one hike priced in for 2016 as of March 29 (higher price translates to lower rates)

More policy tools remain in the Federal Reserve’s monetary tool box

Despite the lack of mentioning on negative interest rates in her speech, Chair Yellen highlighted the following policy tools remain available to counter adverse economic and financial conditions, as well as the central bank’s willingness to deploy these tools “if needed.”  Openly discussing available tools to ease monetary policy is a dovish signal on its own, and market participants took note as intended.

  • QE – increase in the size of SOMA holdings
  • Extend SOMA principal reinvestment – increase in the duration of SOMA holdings
  • Forward guidance about the future path of funds rate

Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.10 While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Cautiousness over firmer core PCE and softer inflation expectations

Chair Yellen repeated her March FOMC comments that the recent rise in core PCE readings deserves further monitoring.

In contrast, core PCE inflation, which strips out volatile food and energy components, was up 1.7 percent in February on a 12 month basis, somewhat more than my expectation in December. 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.

On inflation expectations:

Taken together, these results suggest that my baseline assumption of stable expectations is still justified. Nevertheless, the decline in some indicators has heightened the risk that this judgment could be wrong. If so, the return to 2 percent inflation could take longer than expected and might require a more accommodative stance of monetary policy than would otherwise be appropriate.

Continued concerns over commodity prices

Both Yellen and San Francisco Fed President Williams highlighted shifting Fed view on the effects of weaker oil prices.  In an earlier interview with American Bankers, President Williams suggested that Fed models are now catching up to realize more negative downside risks in the oil sector than previously anticipated.

Two things. One is that oil production has once again grown to be a significant factor — we’re a bigger producer of oil today than we were five or 10 years ago. So that changes how it affects the economy. Jobs in drilling, extraction, all of the ancillary jobs — that whole industry grew rapidly when prices were high and got hammered when they came down.

The second is, the dynamic in the [hydraulic fracturing, or “fracking”] industry is very different than in the rest of the oil industry. Normally, when you’re looking at big oil, if you’re thinking about deep-water drilling, they’re thinking about 10-year, 20-year investments and extraction. All of those decisions are based on long-term views of where things are going to be. Those tend to be, in economics parlance, “stickier” — if the decision makes sense based on our view of the next 20 years, then there’s not much that’s going to happen today that’s going to change my view. And once you start drilling, the marginal cost of pulling that oil out is very low.

With fracking, it’s the exact opposite. You only need a few months to start, you start pulling it out right away, and you’re done in a couple years. So all the dynamics are more like your Econ 101 textbook: Price down? Close. Price up? Do more. That’s something that has really changed to affect the economy. Basically we saw us lose a lot more jobs, a lot more GDP, a lot more losses to the banking industry down the road because this dynamic is quite different. We kind of knew that, but maybe our modeling of that took a little while to [catch up].

Yellen outlined her concerns in terms of global risk factors, although this view is known to financial market participants (President Williams’ view is relatively new, especially on Fed’s model)

For the United States, low oil prices, on net, likely will boost spending and economic activity over the next few years because we are still a major oil importer. But the apparent negative reaction of financial markets to recent declines in oil prices may in part reflect market concern that the price of oil was nearing a financial tipping point for some countries and energy firms. In the case of countries reliant on oil exports, the result might be a sharp cutback in government spending; for energy-related firms, it could entail significant financial strains and increased layoffs. In the event oil prices were to fall again, either development could have adverse spillover effects to the rest of the global economy.

The Fed and its monetary policy transmission mechanism

Yellen and her FOMC allies’ accommodative stance (via communications) induced financial markets to provide further easing via the “recruitment channel” (a term coined by former Fed Governor Stein) – market participants lowered longer-term rates on Fed’s behalf:

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. In particular, foreign economic growth now seems likely to be weaker this year than previously expected, and earnings expectations have declined. By themselves, these developments would tend to restrain U.S. economic activity. But those effects have been at least partially offset by downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending. For these reasons, I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely be limited, although this assessment is subject to considerable uncertainty.

And the public’s reaction function would act as an automatic stabilizer in easing financial conditions.  In short, the “expectation” and “recruitment” channels are essential to the formulation of Federal Reserve monetary policy, hence Yellen’s continued reliance on “soft” forward guidance to shape financial conditions in accordance to changing economic conditions.

Financial market participants appear to recognize the FOMC’s data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important “automatic stabilizer” for the economy. As I have already noted, the decline in market expectations since December for the future path of the federal funds rate and accompanying downward pressure on long-term interest rates have helped to offset the contractionary effects of somewhat less favorable financial conditions and slower foreign growth. In addition, the public’s expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks–a response which serves to stabilize the expectations underpinning hiring and spending decisions.

Indeed – by delivering today’s speech, Chair Yellen had effectively induced financial markets to ease financial conditions on behalf of the central bank, in the forms of lower long-term interest rates (especially the 5 year sector), higher equity valuation, weaker dollar, and tighter credit spreads.

Next article03 28 2016 | by Victor Xing | Economics

February PCE: inflation cools following prior rise