Key points from Janet Yellen’s speech

In April I wrote a blog “Central banks and the certain uncertainty paradox”, reminding everyone that these institutions are no more certain than anyone else about how economic conditions will unfold. Still, market participants continue to hang on every word from the leaders of the world’s major central banks.

Last week was no different. At the Jackson Hole Economic Policy Symposium, a forum for central bankers, policy experts and academics, sponsored by the Federal Reserve Bank of Kansas City, Janet Yellen gave a speech, entitled “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future”, surprising market participants with the conviction of this remark on the possibility of interest rate hikes.

“Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months”.

However, less attention was paid to the caveat that followed: “Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook. And as ever, the economic outlook is uncertain, and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy.”

Everything remains data dependent. The risk with the above remark though is that by signalling a possible rate hike the Fed can influence the behaviour of various market participants, and thus the trajectory for the economy.

Uncertain Outlook

“For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide–a point illustrated by figure 1”

“The shaded region, which is based on the historical accuracy of private and government forecasters, shows a 70 percent probability that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year and between 0 and 4-1/2 percent at the end of 2018. The reason for the wide range is that the economy is frequently buffeted by shocks and thus rarely evolves as predicted. When shocks occur and the economic outlook changes, monetary policy needs to adjust. What we do know, however, is that we want a policy toolkit that will allow us to respond to a wide range of possible conditions.”

I have emphasised the key point in bold, with the wide range of projected outcomes a reminder of the uncertainty around the outlook for the economy and hence monetary policy.

The Past

“Faced with a steep rise in unemployment and declining inflation, the FOMC lowered its target for the federal funds rate to near zero, a reduction of roughly 5 percentage points over the previous year and a half. Nonetheless, a variety of policy benchmarks would, at least in hindsight, have called for pushing the federal funds rate well below zero during the economic downturn. That doing so was impossible highlights the second serious limitation of our pre-crisis policy toolkit: its inability to generate substantially more accommodation than could be provided by a near- zero federal funds rate.”

It is interesting to note that the Fed believe the downturn could have called for pushing the federal funds rate well below zero, perhaps a situation we might see if the US economy is hit with a surprise recession with rates near zero.

The Present

“In light of the slowness of the economic recovery, some have questioned the effectiveness of asset purchases and extended forward rate guidance. But this criticism fails to consider the unusual headwinds the economy faced after the crisis. Those headwinds included substantial household and business deleveraging, unfavorable demand shocks from abroad, a period of contractionary fiscal policy, and unusually tight credit, especially for housing. Studies have found that our asset purchases and extended forward rate guidance put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective.”

Yes, “studies have found”. Of course, we are unlikely to hear of studies that reached an opposing conclusion. Either way, the Fed believe their policies are having a positive impact. Central banks around the world have bought into this model, only time will tell if they were right. Certainly, the case of Japan raises some question marks.

The Future

“By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving. If so, then the average level of the nominal federal funds rate down the road might turn out to be only 2 percent, implying that asset purchases and forward guidance might have to be pushed to extremes to compensate. Moreover, relying too heavily on these nontraditional tools could have unintended consequences. For example, if future policymakers responded to a severe recession by announcing their intention to keep the federal funds rate near zero for a very long time after the economy had substantially recovered and followed through on that guidance, then they might inadvertently encourage excessive risk-taking and so undermine financial stability.”

The big concern among financial market participants is the “unintended consequences” that may arise from the expansionary policies pursued by the world’s central banks since the financial crisis. Interestingly, Janet Yellen does not appear to fear such unintended consequences arising under her watch, warning future policymakers not to be overly aggressive.

What if a recession hits in the near term?

“Finally, the simulation analysis certainly overstates the FOMC’s current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment. But that does not mean that the Federal Reserve would be unable to provide appreciable accommodation should the ongoing expansion falter in the near term. In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly–although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.”

Above is the playbook if the US economy surprises market participants with a recession, but the worry is that the marginal impact of any stimulus will be much less powerful than was the case when the last crisis hit. If a recession hits with rates near zero things could get very messy. Hence, why some market participants are keen to see rates return to more normal levels as soon as possible.

Janet’s Conclusion

“Although fiscal policies and structural reforms can play an important role in strengthening the U.S. economy, my primary message today is that I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns. Additional tools may be needed and will be the subject of research and debate. But even if average interest rates remain lower than in the past, I believe that monetary policy will, under most conditions, be able to respond effectively.”

“Under most conditions”. Those buying safe haven assets like gold are buying protection for the scenario where central bank policy no longer saves the day.