What would Keynes have said about the FOMC press conference?
The observation by British economist John Maynard Keynes that, “in the long run, we are all dead” has added importance in light of the negative response to Janet Yellen’s first press conference. When pushed on the issue of how long is a long period of time following the conclusion of quantitative easing, Ms. Yellen possibly gave away more information than she had wanted by suggesting “six-months”. While on the one hand she has disrupted the fixed income markets, notably the shorter-end of the curve, she now has the market’s full attention. In 2013 when Bernanke let the cat out of the bag on the onset of tapering, he caused similar disruption sending the dollar on a steep upwards trajectory. The market took plenty of persuasion from Bernanke before it dropped its passion for connecting tapering with a stronger dollar. The link between the reduction in its monthly volume of bond purchases and the first take off in the fed funds rate gave way by the end of August as the dollar rally faded into the background.
We feel that despite the removal of the 6-1/2% threshold for the unemployment rate from the FOMC statement, the tone of the Fed’s message changed little this week. As we noted in the aftermath of the press conference, Yellen was quick to attribute equal air-time to the prospect of deflation as she afforded to inflation. In that light it is worth turning back to another famous Keynesian quotation when he noted that “when my information changes, I alter my conclusions. What do you do, sir?”
Several onlookers noted in response to her delivery that the Fed was even more dovish on the prospects for the first increase in rates even though that’s not at all how the market responded. She seemed to draw on the nascent theory that the post financial crisis era has delivered a so-called “new normal”. Under the conditions of still constrained household balance sheets and a slower labor market recovery, the overall economy seems incapable of generating the robust pace of growth that it was so renowned for ahead of the crisis. The permanent removal of profligate lending in an environment of galloping house prices, which in turn reinforced consumption and tighter labor markets, will have lasting impact on the trajectory of the economy. It’s like to be difficult to return to the long-term normal level for interest rates, which the FOMC deems to be around 4%. In that regard it is worth looking at the most and least optimistic views from the Summary of Economic Projections in light of the potential tenure of the so-called “long-run”.
What the fixed income market overlooked most at Yellen’s debut was the fact that not only is inflation missing from the admittedly slow economic rebound, but no one can say with any certainty under this new-norm that it will accompany the economic cycle this time around. If the composition of the employment aspect of the recovery is atypical, then perhaps so too should be the developing trend for inflation ahead. If wage pressures continue on their low trajectory, wage inflation may evade the recovery and leave the Fed with little rationale to push rates higher let alone toward that 4% long-run normal level. The arbiter here will likely be the path of the 10-year yield. Despite the mayhem in the Eurodollar futures market, the yield on the 10-year treasury moved by a mere 6bps to 2.76% as three-month forward yields shifted by as much as 25bps.
What we learned last summer is that when the central bank does something to captivate attention, just as Ms. Yellen appears to have done this week, it takes about three months to recover clarity. Such clarity may be forthcoming in two forms through the spring months. First, we might expect Fed speakers to reinforce the balanced view on inflation in a slow-to-heal labor market. Second, investors could figure that the economic data is likely to continue in its same-old-new-normal way, which hardly calls for any shift in short-term interest rates for a long, long time. In the meantime the volatility stoked by Ms. Yellen could provoke a decent rebound in the allure of the dollar given the jump in two-year yields on the fear that the central bank might act faster than previously thought.