In a speech delivered over the weekend US Federal Reserve Chair Janet Yellen reaffirmed the likely start of US interest rate hikes this year and an only gradual pace of increases thereafter. There’s not a lot new in that but the speech makes an interesting read in highlighting the FOMC’s thinking about the factors likely to determine the interest rate cycle this time around.
On the outlook for the economy Ms Yellen’s comments were mostly in line with the March FOMC statement. Lower energy prices continue to get most of the blame for recent inflation weakness with those effects likely to prove transitory. She acknowledged the impact of the strength in the US dollar in restraining net exports and appears unconcerned about recent weakness in retail sales, expecting consumer spending to grow at a “good clip” this year. With respect to the labour market she says there has been considerable progress on the maximum employment leg of the dual mandate but “appreciable slack” remains.
On interest rates Ms Yellen says the appropriate time for increasing interest rates has not yet arrived but conditions may warrant an increase sometime this year. She points out that policymaker cannot wait until they have achieved their objectives to begin adjusting policy. Leaving interest rates too low for too long risks over-shooting their objectives of maximum sustainable employment and 2% inflation as well as creating risks for financial stability.
Furthermore Ms Yellen stated that neither a pick-up in wage growth nor core inflation are needed before the FOMC decides to begin raising rates. As I’ve said before, waiting for that to happen may leave the Fed having to play catch-up with more aggressive rate hikes The Committee “simply”(my emphasis) needs to believe that conditions are in place for its dual mandate to be met before hiking rates. That said were core inflation or wage measures to weaken, or were inflation expectations to soften, she would be left “uncomfortable” in raising interest rates.
Ms Yellen is clearly attempting to deflect focus from the timing of the first interest rate increase to the shape of the interest rate cycle. Indeed the most important aspect of the interest rate cycle for businesses and households is the cost of capital over the cycle, not the timing of the first hike.
In that respect she spends a considerable part of the speech alluding to the reason why an only gradual rise in the Fed funds rate is likely:
- Firstly, the equilibrium fed funds rate may not recover as quickly as anticipated. That means the ability of the economy to adjust to higher interest rates is uncertain. Ms Yellen highlights the experience of Japan with a tightening of monetary conditions when the equilibrium rate remains low has considerable costs.
- The second factor is the asymmetry in the effectiveness of monetary policy in the vicinity of the lower bound. While interest rates are expected to move higher as the economy improves, should the economy falter as rates rise, there is limited room to stimulate the economy without resorting to further asset purchases with all the risks that would entail.
- Third, she makes the observation that a prompt return to the FOMC’s 2% inflation could be advanced by allowing the unemployment rate to decline below its long run sustainable level for a while.
While all of these are valid reasons for the Fed to move only gradually, it wouldn’t be a balanced speech without highlighting the risk of proceeding too slowly, letting inflation get away, thus undermining the Committee’s inflation fighting credibility. That seems to me to especially relate to the third point above.
In short there’s nothing in this speech to alter our view of a likely September “lift-off” for interest rates in the US and an only gradual removal of monetary accommodation thereafter. But the speech is a more than useful dissertation of what the Fed is thinking about and what they will be watching as the cycle unfolds and the uncertainties that entails.
Regular readers may recall the point we made before the start of the interest rate tightening cycle last year that to some extent the RBNZ (and markets) were on a voyage of discovery with a number of uncertainties about the post-GFC New Zealand economy including the level of the neutral cash rate, the rate of potential GDP, the level of the equilibrium unemployment rate and how businesses and households would respond to higher interest rates.
Ms Yellen concludes her speech with similar thoughts. She reiterates the Committee’s decisions will be data dependent, but that “We cannot be certain about the underlying strength of the expansion, the maximum level of employment consistent with price stability, or the longer run level of interest rates consistent with maximum employment. Policy must adjust as our understanding of these factors changes.” New Zealand’s experience certainly supports that.