Fed: Yellen’s tool-kit analysis argues for more caution than normal - AGFXC

Greg Gibbs, Director at Amplifying Global FX Capital, suggests that the Yellen’s speech was mainly about the how monetary policy toolkit has changed since the Global Financial Crisis in 2007/08 and how it may work in the future.

Key Quotes

“She outlined the main challenge going forward will be the lower outlook for the neutral interest rate, implying there will be less space to use conventional rate cuts to address future economic down-turns.

She anticipates that the Fed may again in future have to rely on the “non-traditional” tools established since the GFC, once rates hit zero.  The first line of defense will be asset purchases (probably Treasuries and Government mortgage backed securities) and forward guidance (saying they will keep rates at zero until at least unemployment falls below 5% or inflation rises above some threshold).

Yellen used a model to argue that these tools could be quite effective and give the Fed sufficient scope to guide the economy (unemployment and inflation) back to normality after “a set of highly adverse shocks.”

However, she also noted concerns that the model may be optimistic, implying the policymakers should consider and be open to widening the toolkit.

Some of these concerns relate to current situation; such as, “an environment where long-term interest rates are also likely to be unusually low.” Or where short term rates were low to start with; in this context she noted that, “By some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving.”

She also acknowledged a short coming with “non-traditional tools” is that “they might inadvertently encourage excessive risk-taking and so undermine financial stability.”

She made it clear that, “the simulation analysis certainly overstates the FOMC’s current ability to respond to a recession, given that there is little scope to cut the federal funds rate at the moment.”

While she did not specifically state it in this speech, the current limited space to cut rates, and the short-comings with relying on non-traditional tools, suggest the Fed should raise rates more cautiously.

There are asymmetric risks to being behind or ahead of the curve.  The negative consequences of being ahead of the curve (tightening too quickly) are greater than being behind the curve.  This supports the notion that the Fed should delay hikes until, as some have described it, it sees the whites of inflation’s eyes.

Looking through the framework on how Yellen sees monetary policy, this speech suggests she may not be convinced yet that the Fed should hike in coming months, and if they do, it will be a long gap before hike three in the cycle.

Cautious and gradual

A key point to take out of all the Fed commentary over the last month is that there is increasing willingness to get another hike done this year, but there is also increasing wariness about hiking through the cycle.  The clearest take away is that the Fed is espousing a gradual and cautious approach.  This suggests that future hikes are more likely to be delayed on any evidence of stalling in growth and less likely to be accelerated on strength.”