Fed’s Yellen Speech Suggest Longer Wait for Rates Hike

The Fed Chair, Janet Yellen on Friday in a speech to the Federal Reserve Bank of Boston’s Economic Conference was more focused on the long-term and structural issues concerning the economy and the dynamics of inflation. She also took a more detailed look at the potential effects and policy implications of extreme economic events such as the 2008 financial crisis.

Yellen said it may be the case that the crisis has done such permanent damage that fiscal and monetary officials will have to retool how they approach their jobs. For central bankers, that would mean keeping a broader set of less conventional tools at the ready, and using them more quickly in a new downturn. The aim, she said, would be to avoid further scarring.

"This post-crisis experience suggests that changes in aggregate demand may have an appreciable, persistent effect on aggregate supply - that is, on potential output," Yellen said, she also added that, "If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand," Yellen said. It would "make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn."

There were however no comments on short-term policy. She also implied that high pressure on policy is necessary for a complete recovery from the crisis. The markets will be in need of explicit guidance and central banks may need to act aggressively and quickly in the event of an economic shock. There were, however, also risks that the costs of pushing aggressive policies for too long a period would exceed the benefits and risk creating financial instability.

The Fed Chair also failed to make any comments on international linkages with research by the Federal Reserve implying that US monetary policy spill-overs to other economies are positive. In other words, policies designed to provide stimulus to the US economy also boost activity abroad as negative effects of dollar depreciation are offset by positive effects of higher US imports and easier financial conditions abroad.

Despite not addressing interest rates or immediate policy concerns directly, Yellen's lunch address on Friday to a conference of policymakers and top academics laid out the growing concern at the Fed that the U.S. economic potential is slipping, and may need aggressive steps to rebuild it. The question, Yellen said, is whether that damage can be undone "by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market. One can certainly identify plausible ways in which this might occur."

"Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending, especially if accompanied by reduced uncertainty about future prospects," Yellen said. "In addition, a tight labor market might draw in potential workers who would otherwise sit on the sidelines and encourage job-to-job transitions that could also lead to more efficient - and, hence, more productive - job matches. Finally, albeit more speculatively, strong demand could potentially yield significant productivity."

Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, "'You don't have to tighten policy just because inflation goes to over 2 percent.'

"Inflation can go to 3 percent, if the Fed thinks this is temporary," said Gundlach, who agreed Yellen was striking a chord similar to summer’s "secular stagnation" thesis. "Yellen is thinking independently and willing to act on what she thinks."

Most market analysts strongly believe that the Fed is likely to raise interest rates in December this year, in a nod to the country's 5.0% unemployment rate and estimations that there will be an increase in inflation, they do not see the Fed moving aggressively thereafter.

"This is a clear rebuttal of the hawkish arguments, to raise rates soon, a line of argument pitched by some of the Fed's regional bank presidents,” said Christopher Low, chief economist at FTN Financial.

U.S. stocks posted further gains after Yellen's remarks, while the dollar dropped and Treasuries rose, pushing yields on the 2-year note to session lows. The EUR/USD moved back above the 1.1000 level before fading again to pre-speech levels around 1.0990. Treasury bond futures initially erased losses, but the moves reversed and there was a steepening of the yield curve.