Interest Rate Inertia: When Will Yellen Pull the Trigger?
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Yellen       

Federal Reserve Board Chair Janet Yellen said today that the central bank’s monetary policy stance of gradually increasing the target for short-term interest rates is “appropriate,” notwithstanding the latest disappointing jobs report, which could signal deeper troubles, as well as drags on the U.S. economy from China’s slowdown and a possible U.K. exit from the European Union.

“My overall assessment is that the current stance of monetary policy is generally appropriate, in that it is providing support to the economy by encouraging further labor market improvement that will help return inflation to 2%,” Yellen said at a much-anticipated speech before the World Affairs Council in Philadelphia, a week before the June meeting of the Federal Open Market Committee (FOMC).

In her last public comments before entering the week-long blackout period in the lead up to the FMOC meeting, Yellen added, “The economic expansion following the Great Recession has now been under way for seven years. The recovery has not always been smooth, but overall, the gains have been impressive. In particular, the job market has strengthened substantially, and I believe we are now close to eliminating the slack that has weighed on the labor market since the recession.”

As such, Yellen said, “I continue to think that the federal funds rate will probably need to rise gradually over time to ensure price stability and maximum sustainable employment in the longer run.” But she refrained from giving away the timing of the next hike – the phrase ‘coming months’ was absent – instead reminding market observers that the Fed is not on a scheduled path of rate changes. “I will emphasize that monetary policy is not on a preset course, and significant shifts in the outlook for the economy would necessitate corresponding shifts in the appropriate path of policy,” she said.

Before Yellen’s Philadelphia speech, the markets were expecting the Fed to raise rates as early as the June meeting. However, the May jobs report released on June 3 dashed those hopes and surprised analysts. The labor market added just 38,000 jobs last month – the lowest since September 2010 and well below expectations. Meanwhile, the Labor Department said unemployment inched down to 4.7% — but it was due to people going uncounted because they left the workforce, according to the statistical methods used, and not from an increase in employment.

Recently, various members of the Federal Reserve, including Yellen, have signaled a readiness to hike rates because the economy has been strengthening. The last time the Fed raised its target for the Fed Funds rate was in December 2015, by 25 basis points. It was the first hike since June 2006, after which the Fed aggressively cut rates to mitigate the effects of the financial crisis.

Yellen said that although the recent labor market report was “concerning, let me emphasize that one should never attach too much significance to any single monthly report. Other timely indicators from the labor market have been more positive.” However, it remains an “important” indicator that the Fed will closely watch. The jobs report showed that weakness was fairly broad-based, even though a strike by 35,000 Verizon workers skewed the figure somewhat.

More generally, Yellen’s outlook on the economy is bullish: “Although the economy recently has been affected by a mix of countervailing forces, I see good reasons to expect that the positive forces supporting employment growth and higher inflation will continue to outweigh the negative ones. As a result, I expect the economic expansion to continue, with the labor market improving further and GDP growing moderately.” In addition to an increase in employment, rising equity and home prices have helped restore household wealth while lower oil prices boosted purchasing power.

Lael Brainard, one of the Federal Reserve’s governors, had signaled a willingness to delay a rate hike. “Recognizing the data we have on hand for the second quarter is quite mixed and still limited, and there is important near-term uncertainty, there would appear to be an advantage to waiting until developments provide greater confidence,” she said in a recent speech before the Council on Foreign Relations in Washington.

Brainard also cited overseas risks that would hamper U.S. growth, such as the June 23 referendum on whether the U.K. will stay in the European Union and pressures facing China and other emerging markets. “Because international financial markets are tightly linked, an adverse reaction in European financial markets could affect U.S. financial markets, and, through them, real activity in the United States.”

Yellen echoed those remarks. “Even though the financial stresses that had emanated from abroad at the start of this year have eased, global risks require continued attention. Much of the turmoil early this year appeared to be associated with concern over the outlook for Chinese growth, which in turn has broad implications for commodity prices and global economic growth.” She also said that a development that could shift investor sentiment is the upcoming referendum on a possible “Brexit.”

“A U.K. vote to exit the European Union could have significant economic repercussions,” she said.

Is a Fed Delay Risky?

Wharton finance professor Joao Gomes believes the Fed will hold off on a rate hike this month as well. “At this stage, markets attach a very low probability to a rate increase at the June meeting. Under the circumstances, the Fed is extremely unlikely to risk a surprise and it’s very likely that we will see them leave interest rates unchanged for the moment.” He adds that the markets do expect a rate hike at least once this year, possibly as early as July but more likely in the early fall. “I think this reflects both the perceived question [about timing] at the Fed and nervousness about the strength of the U.S. economy in the first two quarters of this year.”

Gomes says small, measured increases in interest rates do not pose “any significant danger” to the U.S. or global economies. “I’m also fairly sure that the Fed will be extremely hesitant to raise rates until it is abundantly clear that the U.S. economy is strong enough to absorb such rate hikes.”

But he does have concerns. “From a U.S. standpoint, my main worry is that the Fed is delaying increasing rates until it’s too late. From a global standpoint, I think one could perhaps worry that a decoupling of economic growth between the U.S. and emerging economies would force the Fed to raise rates fairly quickly and spark a wave of capital outflows that would create significant headwinds for those countries,” Gomes says. “This is indeed a possibility, but I think people at the Fed have started to think very carefully about these implications and how they may in turn damage the strength of U.S. corporations and the U.S. financial sector through their exposures to the emerging economies.”

For emerging markets, there is a track record to underline the risks. Wharton finance professor Nikolai Roussanov points to the ‘taper tantrum’ of 2013 as proof. Back then, the Fed announced that it was going to slow down its monthly purchases of Treasurys and mortgage-backed securities, pushing Treasury yields higher. Global investors began selling off their emerging market holdings as the U.S. bond market looked more attractive.

However, keeping interest rates low for a long time carries its own risks. “We are beginning to see significant signs of dislocations in asset markets that may be very difficult to correct later on,” Gomes says. And even if the Fed does return to a “normalized” track soon, this dislocation in the markets might not see a smooth path back. “Much more important is whether such a correction will be smooth. History is full of such episodes where monetary policy stays loose for far too long, with disastrous consequences. The very nervousness in emerging markets about the U.S. interest rate decision is an example of the type of vulnerabilities induced by this massive dislocation in asset prices in the last few years. And many would argue the housing collapse of 2008 was a great example of the Fed letting credit run away and failing to raise interest rates early enough in the cycle to prevent them from getting out of hand.”

Current monetary policy is already “extremely loose by any conventional measure, and still would be if the policy rate was raised another quarter-point,” wrote Bloomberg News’s editorial board in a June 3 opinion piece. “Very low interest rates and a massively expanded central-bank balance sheet (thanks to a prolonged spell of quantitative easing) are distorting asset prices and creating problems for the future. What’s more, as a way to stimulate demand, they seem less and less effective.” That is why a Fed decision not to raise rates would be a “mistake.” Instead, the op-ed said, the government should step up and take more of the burden of stimulating economic growth off the Fed’s shoulders.  “The Fed doesn’t control fiscal policy, but it can and should signal that it’s no longer willing to carry the whole burden of reviving the economy.”

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