Experiential Wealth, Inc.
Experiential Wealth, Inc.
Experiential Wealth, Inc.

Janet Yellen Affirms a Faster Pace to a Lower Neutral

Mar 6, 2017 | FOMC, Individuals, Institutions

  • FOMC Chair Yellen delivered her “From Adding Accommodation to Scaling It back” speech on March 3, 2017, at the Executives’ Club of Chicago. She stated that, if the economic data remains supportive, the FOMC is on track for 75bp (or three 25bp rate hikes) increase this year with more increases in 2018 and 2019 expected. Although the neutral real federal fund rate is expected to remain lower by historical standards, the pace of reaching the neutral rate will be faster than the 25bp increase per year in 2015 and 2016. As always, any decision will be data dependent, and the upcoming March meeting will be no exception (every meeting is a live meeting). Chair Yellen recognizes the limit of monetary policy and that structural changes and fiscal policy are both needed to push the economy forward.
  • We do not believe the FOMC will hike rate in its March meeting. The more recent favorable economic environment is substantially based on expectation and speculation. Chair Yellen and other FOMC members are “talking up” and affirming the likelihood of three rate hikes this year as a way to manage market expectation. FOMC does not like to surprise the markets. We expect the earliest rate hike is during the June meeting if real economic data regarding the U.S. economy and inflation are solidly moving upwards and the Trump Administration’s fiscal and structural reform policies have moved beyond rhetoric.

The following is a summary of the March 3rd speech:

  • Monetary policy cannot be and is not on a preset course. The FOMC stands ready to adjust its assessment of the appropriate path for monetary policy if unanticipated developments materially change the economic outlook.
  • There are limits to monetary policies. Monetary policies cannot address structural challenges or the root causes of income inequality, generate technological breakthroughs or affect demographic factors that would boost real GDP growth over the longer run.
  • 2014 was a turning point when the FOMC began to transition from providing increasing amounts of accommodation to gradually scaling it back (tapering began) by ending asset purchase in October yet not making an immediate shift toward tighter monetary policy
  • Unexpected economic developments and deeper reevaluations of structural trends affecting the U.S. and global economies prompted the FOMC to proceed at a slower pace
  • Going forward, FOMC continues to expect the evolution of the economy to warrant further gradual increases in the target range for the federal funds rate but will not be as slow as 2015 and 2016.
  • FOMC sees interest rate adjustments being the primary tool for actively adjusting the stance of monetary policy in scaling back accommodation
  • FOMC faces two fundamental questions:
  1. How does FOMC assess the current stance of monetary policy?
    • The current stance of monetary policy requires arriving at a judgment of what would constitute a neutral policy stance or the neutral1 “real” federal fund rate at a given time. A wide range of information is necessary when assessing this neutral real rate.
    • Factors contributed to the trailing low neutral rate include slow productivity growth; an aging population in the United States and many advanced economies; below trend inflation rate; subdued economic growth abroad; and a lingering sense of caution on the parts of households and businesses in the wake of the trauma of the Great Recession.
  2. What are the strategic and tactical considerations that underpin FOMC’s decisions about the appropriate stance of monetary policy going forward?
    • Strategically, the FOMC’s monetary policy is based on three basic principles that must be:
      1.  goal driven which are consistent with the dual mandates over time
      2.  forward looking (2-3 years ahead) because decisions tend to influence economic activity and inflation with a substantial lag
      3.  risk sensitive because the outlook is uncertain. FOMC assess appropriate policy with an eye toward the risk that expectations about the economy turn out to be significantly wrong.
    • Tactically in response to the financial crisis led deep recession and painfully slow recovery, the FOMC has adjusted by using tools such as the large scale securities purchases and explicit forward guidance regarding federal fund rate path.
  • 2015 and 2016 both brought some unexpected economic developments in the U.S. and globally which led the FOMC to proceed cautiously. In addition to the uncertainty regarding job market and inflation, FOMC and most private forecasters generally lowered assessments of the longer-run neutral level of the real rates here and abroad. This reassessment reflected, in part, the persistence of surprisingly sluggish productivity growth globally and suggested that fewer federal funds rate increases would be necessary than previously thought to scale back accommodation.
  • With the U.S. economy showing resilience during the second half of 2016 and the job market strengthening and inflation rising toward the 2 percent target, the FOMC suggested that a cumulative ¾ percentage point increase (or three rate rises) in the target range for the federal funds rate would likely be appropriate over the course of 2017 and projected additional gradual rate hikes in 2018 and 2019.
  • In conclusion, at the March meeting, FOMC will evaluate whether employment and inflation are continuing to move in line with expectations, in which case a further adjustment of the federal funds rate would likely be appropriate. (She did not confirm that the adjustment would take place in the March meeting.) Further, unless unanticipated developments adversely affect the economic outlook, the process of scaling back accommodation likely will not be as slow as it was during 2015 and 2016.

This commentary is for informational purpose only. Opinion expressed herein should not be relied upon to make any financial or investment decisions or to make any changes to your financial condition.

1 The level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a “neutral” policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator.

© Chao & Company. Ltd. 03-2017