"So What Did We Learn From Yellen?": Deutsche, Goldman Explain

For those still unsure what Yellen's rambling, disjointed press conference meant yesterday, or are still in shock over the Fed's admitted confusion by the "mystery" that is inflation, here is a quick recap courtesy of Deutsche Bank and Goldman, explaining what we (probably) learned from the Fed and Yellen yesterday.

First, here is DB's Jim Reid:

So what did we learn from the Fed and Yellen last night? Firstly we learnt that stopping reinvestment is a sideshow for now and that the market still cares more about the probability of a December hike and where the Fed thinks inflation is heading. Just briefly on the balance sheet run-off, they have committed to the plan from the June meeting of $10bn per month ($6bn USTs and $4bn Mortgages) with an incremental increase every 3 months until we get to $50bn. However on the rates and inflation outlook the committee and Yellen were on the hawkish side. As DB's Peter Hooper discusses in his note, barring negative surprises in the months just ahead, the Fed is on track to raise rates once more this year and three times in 2018. Yellen recognised that inflation has been running low recently but put a higher blame on one-off factors than was perhaps anticipated. At the same time she noted that monetary policy operates with a lag and that labour market tightness will eventually push inflation up.


The complication for markets though is that beyond 2017, the FOMC will see a huge upheaval in its membership which could easily mean current member's thoughts are meaningless in a few months time and also that Mr Trump's fiscal plans (or lack of them) have the ability to completely change the debate. So its difficult to read too much into the current FOMC's forecasts. However for now December is very much live with the probability of a December rate hike moving from a shade under 50% to 64% by the US close (using Bloomberg's calculator).

Here are three additional takeaways from DB's Peter Hooper:

  1. Inflation: Yellen emphasized in her statement and in answers to questions that, barring negative surprises in the months just ahead, the Fed is on track to raise rates once more this year and three times in 2018. She recognized that inflation has been running low recently, and that while there was some uncertainty around this performance, one-off factors that are not expected to persist, and which have not been associated with the performance of the broader economy, have been important. At the same time, Yellen noted that monetary policy operates with a lag and that labor market tightness will eventually push inflation up. The Fed wants to avoid having to tighten policy aggressively to deal with an inflation problem and thereby cause a recession. The current low level of inflation allows the Fed to move relatively slowly and cautiously. At the same time, as Yellen noted a couple times, the labor market has continued to tighten at an impressive pace, well above the pace needed to stabilize unemployment. With unemployment already below NAIRU and expected to fall further, it is seen as prudent to make further progress in a tightening direction.
  2. Balance sheet versus fed funds rate: The preferred monetary policy tool, if needed, is the fed funds target. Yellen stated clearly several times during the press conference that balance sheet rundown will not be stopped or reversed unless the economy takes enough of a significant hit to cause the FOMC to move the fed funds rate back close to zero.
  3. Regulation and who will be the next Chair: When asked what message she had meant to give the Administration and Congress in her Jackson Hole speech, Yellen said first that it was important to keep in place progress that had been made in strengthening the financial system via enhanced capital and liquidity requirements, stress testing, and resolution plans. But she also emphasized that regulators should look for ways to ease excessive regulatory burden and simplify standards where appropriate. She seemed to give proportionately more time to the second part of this message in her answer today than she did in her Jackson Hole speech. She also noted that she would welcome and work very well with the new Vice Chair for regulation, Randall Quarles, if his appointment is approved by the Senate. And she gave a fairly accommodative answer to a question about the burden that the slow progress in getting vacant governor seats filled (especially following Vice Chairman Fischer’s departure) imposes on the Board. Finally, she gave a relatively gentle answer to a question about fiscal policy (suggesting it would be desirable to make progress on measures that would support productivity growth). Summing up Yellen’s various comments in these areas, it strikes us that this is a person who would accept a second term as Fed chair if the Administration chooses to move in that direction.

Finally, here is a Q&A from Goldman's Jan Hatzius, who now gives 75% odds to a December rate hike:

Q: Will the FOMC hike the funds rate in December?


A: Yes, probably. Fully 12 out of 16 FOMC participants—the same number as in June and almost certainly including the leadership—think another hike this year looks appropriate. Given the calendar, this amounts to fairly strong forward guidance for a December hike. Consistent with this, the committee upgraded the 2017 growth outlook from 2.2% to 2.4% and lowered the 2018-2019 unemployment forecast from 4.2% to 4.1%. And Chair Yellen again downplayed the significance of the weak core inflation data this year, saying that this “primarily reflects developments that are largely unrelated to broader economic conditions” and “as long as inflation expectations remain reasonably well anchored [these developments] are not a concern because their effects fade away.” Given this relatively strong message, we have increased our subjective probability of a hike in December from 60% before the meeting to 75% now. A hike is not assured, but we would now probably need a meaningful downside surprise in the inflation data relative to the Fed’s reduced expectations and/or a big market deterioration to forestall it.


Q: Was the longer-term message similarly hawkish?


A: No, on the contrary. The longer-term dots moved down by more than we (and we think most others) expected. The median pace of hikes was unchanged at three for 2018 but fell to just over two in 2019, and the longer term funds rate came down from 3% to 2.75%. Again, these moves were consistent with the message from Chair Yellen in the press conference. She said that the neutral real federal funds rate, r*, had fallen substantially and was likely to remain low, rising only to 0.75% in the longer term. And she also said that the risks to the (actual) path of the funds rate relative to the modal forecasts in the dot plot were tilted to the downside, rationalizing the very depressed market-implied path of the funds rate, at least in part.


Q: If the message was so mixed, why did the bond market take today’s news as clearly hawkish across the yield curve?


A: Three reasons. First, the dots represent a form of forward guidance in the near term—especially this late in the year, when a 2017 hike would almost certainly occur in December—but are only an opinion in the longer term, albeit a well-informed one. Second, the committee will see a substantial amount of turnover in coming years, and new participants could come with very different views. And third, the dots remain considerably above market pricing, even after Wednesday's downward revisions.


Q: Are you lowering your own longer-term funds rate projections along with the FOMC?


A: No, we have kept our working estimate of the terminal funds rate at 3¼%-3½% in nominal terms and 1¼%-1½% in real terms. We are more skeptical than the committee that the notion of a depressed neutral funds rate is a useful concept for predicting monetary policy in the medium and longer term. It may well be that r* will remain below the historical norm, and our projections do, in fact, build that in to some degree. There is a solid economic rationale for the idea that lower potential GDP growth should imply a lower equilibrium interest rate. But while the idea is intuitive, the empirical support for it is weak—much weaker than assumed in the well-known Laubach-Williams model of equilibrium interest rates as well as large swaths of the current macroeconomic debate. So we would put less weight on that link in projecting interest rates several years into the future, and more weight on the historical average real rate of about 2%.


Q: Any surprises on balance sheet normalization?


A: Not as far as the near term is concerned, but Chair Yellen indicated that the hurdle for stopping balance sheet rolloff is very high indeed. Our read of her discussion in the Q&A was that full reinvestment would only resume once the committee had cut the funds rate back to the effective lower bound. This would be consistent with a sentence from the March 2017 FOMC minutes that read: “A number of participants indicated that the Committee should resume asset purchases only if substantially adverse economic circumstances warranted greater monetary policy accommodation than could be provided by lowering the federal funds rate to the effective lower bound.” In the March 2017 minutes, this view was still contrasted with an alternative view held by “some” that reinvestment should resume before the committee returned to rate cuts. But Yellen’s comment today suggests that at least the current FOMC thinks balance sheet normalization is now truly on “autopilot”, barring a very bad economic outcome.