Now that Fed Chairperson Yellen’s testimonies are done, let’s sit back and take stock of some of the major points that she made, shall we?
Specifically, let’s take a look at Yellen’s views on the U.S. economy and monetary policy.
Yellen noted that average job gains in the latter half of 2016 came in at 190K per month, which is good because it’s way above the 100K that’s needed to keep up with working-age population growth. And that plus the previous gains, as well as the 227K gain in January, “bring the total increase in employment since its trough in early 2010 to nearly 16 million.”
Yellen also pointed out that the unemployment rate was 4.8% in January, which “is more than 5 percentage points lower than where it stood at its peak in 2010 and is now in line with the median of the Federal Open Market Committee (FOMC) participants’ estimates of its longer-run normal level.” The number of people who are working part-time but would like a full-time job has also fallen. Finally, wage growth “has picked up relative to its pace of a few years ago, a further indication that the job market is tightening.”
Overall, a pretty upbeat assessment of the labor market. The only thing that disappointed Yellen was that the jobless rate for “minorities remain significantly higher than the rate for the nation overall.” But again, an upbeat assessment overall.
Yellen highlighted the recent rise in inflation, attributing it primarily to “the diminishing effects of the earlier declines in energy prices and import prices.”
However, Yellen noted that the personal consumption expenditures (PCE) index, the Fed’s key inflation indicator, only rose by 1.6% in the 12 months to December 2016, which is still a few ticks away from the Fed’s 2% inflation target. Yellen was quick to add that the reading is still “up 1 percentage point from its pace in 2015,” though, giving her statement an optimistic spin.
Moving on, I noted in my 3 Takeaways from the February FOMC Statement that the Fed had not-so-hawkish undertones with regard to market-based measures of inflation compensation. Well, Yellen removed those not-so-hawkish undertones when she said the following (emphasis mine):
“It is reassuring that while market-based measures of inflation compensation remain low, they have risen from the very low levels they reached during the latter part of 2015 and first half of 2016.”
Overall, an optimistic view on inflation, with a noticeably more hawkish tone compared to the February FOMC statement.
Yellen noted that U.S. real GDP grew moderately by 1.9% in 2016, the same pace as in 2015. And that was due to the healthy rise in consumer spending. And the rise in consumer spending, in turn, was due to “steady income gains, increases in the value of households’ financial assets and homes, favorable levels of consumer sentiment, and low-interest rates.”
However, Yellen lamented that “business investment was relatively soft for much of last year.” Yellen blamed the weakness in investment spending on “weak foreign growth and the appreciation of the dollar over the past two years,” which restrained investment in the manufacturing sector. Another factor was the higher mortgage rates, which restrained housing construction and may continue doing so.
Congressman Andy Barr later grilled Yellen on U.S. growth during the second day of testimonies, citing the Fed’s past forecasts on GDP growth and the resulting downgrades whenever growth fell short of expectations, which happened more often than not, so much so that Congressman Barr referred to it as a “serial failure” on the Fed’s part.
Well, Yellen replied as follows (emphasis mine):
“So the Congress’ instructions to the Federal Reserve are to try and achieve maximum employment and price stability. We’ve focused on those objectives, not economic growth per se, but maximum employment. The economic growth performance has been quite disappointing and growth has fallen short of expectations, but unemployment has come down substantially, and we’re quite close, I would say, to achieving our labor market objectives. Now, the reason for this is that productivity growth in the U.S. economy, which is what really determined in the long-run the pace of growth our economy is capable of, has been very disappointing.”
In short, Yellen justified the weakness in economic growth (relative to historical U.S. average growth of around 3.2%) by saying that the Fed is not focused on economic growth. Overall, Yellen tried to present an optimistic face when talking about GDP growth. But as revealed during the Q&A session, Yellen also admitted that “economic growth performance has been quite disappointing and growth has fallen short of expectations.”
With regard to monetary policy, Yellen had this to say (emphasis mine):
“As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”
Pretty hawkish, yeah? There’s more (emphasis mine):
“Incoming data suggest that labor market conditions continue to strengthen and inflation is moving up to 2 percent, consistent with the Committee’s expectations.. 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.”
As usual, though, Yellen gave the usual caveats, saying that “the economic outlook is uncertain, and monetary policy is not on a preset course.” She also noted that uncertainty from possible changes in U.S. fiscal and other policies “could potentially affect the economic outlook.” Although she didn’t really provide any details when grilled during the Q&A session.
Moving on, Yellen was also asked whether the Fed has any plans to shrink the Fed’s “bloated” balance sheet during the Q&A session of both testimonies. And for reference, the Fed’s balance sheet currently stands at around $4.5 trillion.
Yellen replied on both occasions that the Fed won’t be shrinking the balance sheet until the Fed Funds rate is “high enough to be reduced again in the event of economic turbulence.” During the second day of testimonies, Yellen was asked to quantify “high enough“. And, well, Yellen gave a rather evasive answer, saying that “there’s no unique level“. Yellen did later say that the Fed “would be discussing reinvestment policy in greater detail” in upcoming meetings.
By the way, the Fed’s current practice is to maintain its balance sheet by reinvesting principal repayments, thereby creating artificial demand in the bond market, which depresses bond yields and helps keep long-term borrowing costs low, thereby helping out companies (and consumers as well).
My point here is that rate hikes are not the only way to remove accommodation, since shrinking the Fed’s balance sheet means lower artificial demand for bonds, higher bond yields, and higher-borrowing costs (as well as a stronger dollar). Basically, a similar effect on borrowing costs as hiking rates.
The market was taken by surprise by Yellen’s rather hawkish rhetoric during the first day of testimonies. As such, the Greenback rose together with rate hike expectations.
Odds for a March rate hike, for example, rose from 13.3% to 17.7%, according to the CME Group’s FedWatch Tool.
Rate hike odds don’t go above 50% until the June FOMC meeting, though. By the way, the odds for a June rate hike improved from 65.3% to 68%.
The second round of testimonies also helped improve rate hike odds, especially since positive U.S. economic reports were released ahead of Yellen’s testimony.
Odds for a March rate hike surged to 31%.
And odds finally went above 50% for the May FOMC meeting, instead of the June FOMC meeting. To be more specific, rate hike odds in May jumped from 40.6% to 51.7%.
Despite the higher rate hike expectations, the Greenback tanked just before and after Yellen’s testimony. Some market analysts blamed that on profit-taking after an 11-day Greenback rally.
Other market analysts, meanwhile, placed the blame on disappointment over the details of some of the U.S. economic reports. Yet others also point to U.S. bond yields coming off their highs and the disappointing turn in Yellen’s rhetoric during her second testimony, particularly her comment about “disappointing” U.S. economic performance.
I kinda lean more towards those who point to profit-taking and U.S. bond yields pushing away from their highs. As noted earlier, Yellen did stress that the Fed plans to hike rates to a “high enough” level first before shrinking its balance sheet. Her comment about “disappointing” U.S. growth, meanwhile, is within the context of the Fed’s dual mandate. And growing the economy at a faster pace is not one of them, as Yellen explained.