Exerting control in a decidedly dovish direction
The main takeaway, in our view, from Chair Yellen’s comments before the Economic Club of New York, is that a combination of higher external risk factors, downward revisions to committee member’s estimates of the long-run policy rate, and the asymmetry of monetary policy at the zero lower bound caused the committee to turn more cautious at its March meeting.
Her comments stand somewhat in contrast to recent remarks by other FOMC members and are more clear in respect to downside risk factors and their possible effect on the outlook for activity and inflation. Hence, we see the chair’s comments today as an effort to exert control over the message and, in doing so, tilt expectations for policy rate hikes in a decidedly dovish direction.
We maintain our view that the Fed will raise its policy rate twice this year, in June and December, but risks to our call remain skewed to fewer hikes, particularly if market concerns around the upcoming UK Referendum vote keep financial conditions tight through mid-year. Our policy rate forecast is predicated on our view that external risk factors will not unduly influence domestic activity, allowing for a continued decline in the unemployment rate and a gradual building of inflationary pressures.
External risk factors played a role in staying the committee’s hand in March. While the March FOMC statement was not exceptionally clear about the FOMC’s assessment of the balance of risks to the outlook, we interpreted the language in light of the decision to flatten the dot chart by 50bp in 2016 as a clear sign that the committee saw downside risks as having risen.
Chair Yellen’s remarks today are consistent with this view. In her written comments she said the committee had to “take into account the potential fallout from recent global economic and financial developments,” which she sees as influenced by developments in China and the prospect of lower oil prices. While the transition to a slower growth outlook in China is no surprise in terms of its placement on a list of risk factors, the explicit reference to lower oil prices as a risk factor is a surprise relative to previous FOMC communications.
Nearly all Fed commentary to date about oil prices has highlighted the positive benefits that would accrue to the US economy, and the US consumer in particular, despite the negative effects on oil extraction activity. Chair Yellen was explicit in saying that lower oil prices now pose a risk to spending and activity in oil export-dependent economies, particularly if lower oil prices coincided with a stronger dollar.
External risk factors also weigh on the chair’s assessment of inflationary pressures. The combination of slow growth abroad, falling oil prices, and a stronger dollar would, in her view, slow progress in labor markets and extend the time it takes for inflation to return to the committee’s 2% inflation objective. This is particularly true if long-run inflation expectations were to drift lower. While the chair’s remarks indicate she sees inflation expectations as stable, she acknowledged that “the decline in some indicators has heightened the risk that this judgment could be wrong.”
Hence, the chair is willing to look through recent strength in core goods prices, which has propelled core PCE inflation to 1.7% y/y, saying “it is too early to tell if this recent faster pace will prove durable.” This is consistent with our view that the committee will likely need to let the unemployment rate drift lower to support actual and expected inflation amid a weak external inflation backdrop (see Target 4% unemployment to achieve 2% inflation. By letting domestic labor market conditions heat up further, confidence within the committee about its inflation outlook should improve.
The committee was more willing to take on board the implications of a lower neutral policy rate. While Chair Yellen, and other Fed communications, have highlighted for some time the likelihood that the equilibrium real rate of interest had fallen, the comments today suggest that many committee members finally took the implications of this assessment on board when writing down their policy path and long run policy rate. In her written remarks the chair said that “the level of the real federal funds rate…is likely now close to zero” and she followed that up in the Q/A session by saying many committee members lowered their estimate of the long-run policy rate in the March projections. This, plus higher external risks to the US outlook, led members to mark down their near-term policy path. We agree that the natural rate of interest has fallen, and estimate the real policy rate to be only modestly above.
Furthermore, although the chair continues to state that the equilibrium policy rate is expected to rise, the factors behind this outlook remain “highly uncertain” in her view. The rebound in the natural rate of interest is dependent on a variety of assumptions, including a fading of external risk factors, and acceleration in productivity growth, and faster potential growth. In a response to a direct question about productivity growth, the chair said that low productivity growth was surprising and unanticipated. She called the outlook for a rise in productivity “highly uncertain.” Should the real equilibrium policy rate stay low, the committee will likely be lowering its 2017 policy path in the same manner that it just did with its 2016 policy path; that the committee has not done this already demonstrates an unwillingness to fully prejudge the outcome. If the combination of slow growth, modest inflation, and falling unemployment continues, the committee will likely continue to revise lower its outlook for potential growth, NAIRU, and the natural rate of interest.
Finally, asymmetry in the efficacy of monetary policy at the zero lower bound favors caution. The chair repeated the view that policy remains hamstrung by the zero lower bound since the committee believes it is easier to raise rates if it finds itself behind the curve as opposed to providing further stimulus if policy tightens too quickly or if activity deteriorates.
Michael Gapen, Rob Martin
Economics Research Instant Insights
Barclays