On Tuesday, Janet Yellen delivered what some observers called her finest “performance” since ascending to the monetary throne in February of 2014.
Of course in the post-crisis world, central bankers are only praised when they make dovish pronouncements. Hawks are heretical. To tighten is to sin.
The conundrum for Yellen is that she appears to have been talked into going along with the global easing bias for a few more months at the G20 - data be damned. That is, despite the fact that the US economy is about to hit full employment (and we’ll ignore the fact that the numbers are goalseeked and that the only jobs being created are lowly service sector positions), Yellen has to find an excuse to avoid adopting too steep a “flight path” for rates, lest the dollar should soar causing commodities to plunge anew and triggering massive outflows from EM.
With no way to justify a dovish tilt based on the dual mandate (inflation isn’t exactly where the FOMC would like it to be, but compared to Japan and Europe it looks rather robust), Yellen did the only thing she could this month: she admitted (just as she did in September) that the reaction function now includes international financial markets and, more specifically, China.
That admission was greeted with a high degree of skepticism last autumn, but it would appear that now, having proven that it’s at least possible to hike 25 bps without the entire world coming to an end, the market is more than happy to see the Fed stand pat if it means forestalling global turmoil. As we noted this morning, some Fed officials didn’t get the message and so on Tuesday, Yellen the “mother lion” was forced to “swat her misbehaving cubs back into line” (to quote Bloomberg’s Richard Breslow) with an uber dovish speech at the Economic Club of New York.
The message the vaunted Fed chair sought to drive home was simple: it wouldn’t matter if the unemployment rate dropped to 1% and inflation expectations spiked above the FOMC’s target overnight - it’s simply too dangerous out there for the Fed to lean hawkish. Or, as BofA puts it in a new note: “It’s a big scary world out there.” Excerpts are below.
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It's a big scary world out there
Fed Chair Janet Yellen, in her speech and subsequent Q&A at the Economic Club of New York, was very clear in conveying her message that the weak global backdrop is preventing the Fed from hiking rates very much. While the Fed's baseline economic scenario was roughly unchanged between the December and March FOMC meetings - given appropriate monetary policy accommodation - uncertainties are higher due to a weaker path of projected global growth. In other words the reduction in the dot plot to two rate hikes this year at the March meeting, from four hikes in December, is thought appropriate to mitigate the impacts of the weaker global backdrop. That reinforces the impression from the last FOMC meeting that the Fed is willing to risk higher inflation over the longer term in order reduce shorter term uncertainties. Hence the increase in 5-year, 5-year forward inflation expectations and simultaneous decline in equity vol following today's comments by Chair Yellen (Figure 1).
Why the Fed matters
To illustrate why the Fed's clear shift to a more dovish stance is so effective in reducing uncertainties in financial markets, consider our recent survey of US credit investors. Arguably at least three - if not all - of the top-4 investor concerns - China, Oil prices, Geopolitical risk and Slow recovery (in that order, Figure 2) - are mitigated to some extent by the more dovish Fed. First of all a more aggressive Fed rate hiking cycle would likely accelerate China's capital flight which, with an open capital account, leads to the equivalent of monetary policy tightening in China at a time where the weak economy needs the opposite. Furthermore, to stem such capital flight incentivizes the PBOC to pursue more aggressive currency depreciation, which is very deflationary through commodities. Second the stronger dollar associated with a more aggressive Fed puts downward pressure on oil prices - instead the USD weakened 0.8% today. Third to some extent even geopolitical risk is related to lower oil prices. Fourth the stronger dollar and lower oil prices could initially be negative for the US economy through the manufacturing sector - before consumers eventually do react to lower prices at the pump.