Fed Chair Janet Yellen will deliver her inaugural monetary policy testimony on February 11 and 13. Her prepared remarks will be released at 8:30amET and the testimony will begin at 10amET. Goldman, unlike the market of the last 3 days, believes that Ms. Yellen is likely to "stick to the script" in her first public remarks since taking over from Bernanke but they look for additional color on the following issues: (1) the recent patch of softer data; (2) the Fed's thinking on EM weakness; (3) the hurdle for stopping the taper; (4) the amount of slack in the labor market; and (5) the future of forward guidance.
Via Goldman Sachs,
1. How much does Ms. Yellen worry about the softer data?
The US economic data have disappointed since the start of the year. Following last week's weaker-than-expected employment and ISM manufacturing reports, our US-MAP surprise index has fallen further into negative territory and our current activity indicator (CAI) has slowed from an average of 3.1% in October/November to 2.3% in December/January. But, given a number of special factors, we think this is a pothole after a much stronger-than-expected 2013H2, not the beginning of yet another swoon. More broadly, our confidence in the fundamental drivers of stronger US growth remains high and we continue to expect growth of about 3% this year. We will take note of the degree to which Ms. Yellen views the recent patch of softer data as transitory. A new set of formal economic projections is not due until the March FOMC meeting, and we expect Ms. Yellen's message to remain broadly consistent with the committee's December forecast of 3% growth in 2014.
2. How are Fed officials thinking about the EM weakness?
The recent turbulence in emerging economies and markets raises two questions for Fed officials. The first is whether the turmoil is related to the Fed's tapering. As our EM Markets team has noted, we think that the EM difficulties reflect a need for significant adjustments in a range of countries in an environment of higher global real interest rates and lower commodity prices. While rising US rates--and therefore to some extent Fed policy--were a catalyst, the fundamental source of pressure lies in the domestic and external imbalances within EMs that need correction. The second question is the extent to which the EM turmoil might spill over into the United States. Given the limited exposure of the United States to the EM world, we are not too worried about adverse spillovers. Emerging economies as a group only account for a relatively small share of US exports, banking claims, and corporate profits, and the numbers decline further if we focus on the most troubled EM countries. We would expect Ms. Yellen to take a similar view but will look out for any color on these issues.
3. What is the hurdle for stopping the taper?
We believe that the hurdle for a pause in the tapering process is still fairly high. While the Committee has taken pains to note that the path of asset purchases is “not on a preset course,” a substantial change in the outlook would likely be required for the Fed to either pause or accelerate the gradual pace of tapering started in December. We think this relatively high bar has not been met. This is partly because of our interpretation of the recent dataflow discussed above and partly because, at this point, Fed officials appear to have little confidence that they can use small moves in the QE pace to fine-tune their monetary impulse. After the events of last summer, they are probably particularly reluctant to signal an increase in the pace of tapering, now that the program is on a natural course toward expiration well before the point at which the FOMC expects to hike the funds rate. The hurdle for interrupting the tapering process in response to weaker growth or lower inflation might be a bit lower, but we believe that the surprise would still need to be more meaningful than what we have seen in recent weeks. We would expect Ms. Yellen to deliver a similar message.
4. How much slack does the economy have?
One of the key questions for the US economy is how much slack remains in the labor market. The size of the employment gap appears particularly uncertain at present because it is unclear to what extent the unemployment rate is representative of the amount of slack in the labor market. On the one hand, the unemployment rate might overstate the amount of slack in the labor market because the short-term unemployment rate has already fallen significantly. On the other hand, the unemployment rate might understate the employment gap because the weakness in labor force participation is partly cyclical. While the uncertainty is significant, we see the evidence as more consistent with the latter view. Fed commentary on this issue suggests that there is a range of opinions on the committee. Former Chairman Bernanke was generally non-committal, highlighting the importance of both cyclical and structural factors (such as demographics). We would expect Ms. Yellen to indicate that a significant amount of slack remains despite the drop in the headline unemployment rate, and that more and broader labor market improvement is needed before the FOMC will consider an increase in short-term interest rates.
5. What will happen to forward guidance?
Finally, we will take particular note of any remarks regarding potential changes to the forward guidance. The most immediate question is how Fed officials think about guidance for the first rate hike now that the unemployment rate is very close to its threshold. A cosmetic adjustment to the guidance appears needed once the unemployment rate drops below 6.5%. But we would expect Fed officials to rely mainly on qualitative guidance in the near term given the apparent lack of support in the December meeting minutes for more forceful enhancements, such as reducing the unemployment threshold to 6.0%.
The other important question is whether the committee will provide additional guidance for the pace of policy normalization once the first rate hike occurs. The FOMC statement currently states that “when the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.” Ms. Yellen said in March 2013 that the committee’s current forward guidance is “not complete” because it “has not specified exactly how it intends to vary the federal funds rate after liftoff from the effective lower bound.” Ms. Yellen concluded in April 2013 that “as the time of the first increase in the federal funds rate moves closer… it will be increasingly important for the Committee to clearly communicate about how the federal funds rate target will be adjusted.”
We argued last week that an attractive approach to providing additional forward guidance in the present circumstances might be to stress the role of nominal wage growth for Fed policy. The uncertainty around the extent of labor market slack makes agreement on quantitative guidance difficult to attain. But we showed that Fed officials can, in principle, mitigate this problem by responding less to the poorly measured employment gap and more to nominal wage growth. This is true even if Fed officials care greatly about employment; the reason is that wage inflation acts as a cross check for (imprecisely measured) labor market slack. While such a policy is not perfect—as the link between wages and slack, too, is subject to uncertainty—the scope for error is lowered significantly. Ms. Yellen may therefore well indicate that wage inflation is one of the key markers for broad labor market improvement and, therefore, the committee's thinking about the funds rate path.