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What's Janet Yellen Up to?

Written By Briton Ryle

Posted March 20, 2014

Well, the markets have done it again. They keep fixating on a few words spoken by the Federal Reserve Chairperson to the exclusion of the broader context within which they were spoken.

They did it on May 1st of 2013 when then Fed Chairman Bernanke stated the monthly asset buying program would end by mid-2014, triggering panic selling in equities and bonds not just across U.S. markets but around the world.

And they did it again yesterday, when current Fed Chairwoman Yellen answered a reporter’s question on the possible timing of interest rate hikes.

It started innocently enough. The central bank’s Federal Open Market Committee announced yesterday after the close of its two-day meeting that it would reduce its monthly purchases of U.S. Treasuries and mortgage backed securities by another $10 billion – the third such reduction since tapering began last December – bringing its purchases down to $55 billion a month.

The reduction of stimulus by another $10 billion per month came as no surprise to the markets, since the Fed had already made known its plan to whittle down its monthly purchases to zero by the end of this year, to be followed by a gradual raising of interest rates back to normal levels.

What caught the markets off guard, however, was Chairwoman Yellen’s answer to the question: “Once you do wind down the bond buying program, could you tell us how long a gap we might expect before the [interest] rate hikes do begin?”

Her answer sent the S&P 500 index falling 18 points – nearly a full percentage point – in just 10 minutes before rebounding slightly to close the day down 11.48 points (a 0.61 percent change). Bonds were also dumped, with the 10-Year Treasury yield widening by 10 basis points (a 3.7 percent change). The 10-Year’s yield at 2.75 percent is just a third of a percentage point away from 2.5 year highs. Even gold lost some $25 by the end of the day’s trading on the expectation that interest rates rising sooner than expected will strengthen the dollar and weaken commodities.

Just what did Yellen say that spooked the markets so? Could this be what finally triggers the long anticipated correction in equities?

Redefining “Considerable”

For years the FOMC had informed the markets that the federal funds rate – the interest rate banks pay for federal funds borrowed from the Federal Reserve and amongst themselves – would remain between 0 and 0.25 percent “for a considerable time after the [monthly] asset purchase program ends”, as cited in all its recent press releases.

For some time, then, the understanding was that even after the Fed stops tossing money into the economy through its monthly purchases, it would continue to stimulate the economic recovery by keeping money ultra cheap for a “considerable time” – which most perceived to be from several quarters to as much as two full years into 2016.

What was Yellen’s answer to the reporter’s question on the time frame between the end of the monthly purchases and the beginning of interest rate hikes? “The language that we use in this statement is ‘considerable’,” she responded. “This is the kind of term that’s hard to define, but it probably means something on the order of around six months.”

Six months?! If the monthly asset purchases program is on track to terminate before the end of this year, then six months after that would mean interest rates could begin rising as early as April to June of 2015 – almost a full year sooner than most were projecting.

But hold your horses, everyone; the Chairwoman wasn’t finished. “It depends [on] what conditions are like,” Yellen added. It is not six months cut and dry. It will be “around” six months, and it will depend on the condition of the economy at that time.

The question now is… what conditions will the Fed be looking for? The Fed would have to see two conditions in particular which are in line with the FOMC’s dual mandates of achieving “maximum employment and price stability”. Chairwoman Yellen went on to describe those two conditions in detail.

A Shift in the Employment Factor

As the first condition before raising interest rates, the FOMC will continue to focus on employment, as Yellen elaborated, “We need to see where the labor market is, how close are we to our full employment goal. That will be a complicated assessment, not just based on a single statistic.”

That “single statistic” referred to is a 6.5 percent unemployment rate, which the FOMC had for some time used as a guide. The idea was that when the unemployment rate falls below 6.5 percent, the Fed would “consider” raising interest rates.

But the unemployment rate has been sitting between 6.7 percent and 6.6 percent for the past three months with still not enough indication that the economy is strong enough to withstand interest rate hikes just yet. So the FOMC is dropping that 6.5 percent unemployment rate threshold as a factor in its decision making, as indicated in yesterday’s press release:

“With the unemployment rate nearing 6.5 percent, the Committee has updated its forward guidance. The change in the Committee’s guidance does not indicate any change in the Committee’s policy intentions as set forth in its recent statements.” In other words, the FOMC isn’t changing course just yet; it is merely changing they way it provides its forward guidance.

Instead of looking at 6.5 percent unemployment rate threshold, the Fed will instead be taking the overall condition of the labor market into consideration when making its decisions.

“We need to assess the labor market continues to be on the mend, and that we feel reasonably satisfied that the outlook is for further improvement in the labor market that will get us back to our maximum employment objective,” Yellen added in response to a later question.

Inflation Still a Big Factor

The second key economic condition that will continue to shape the FOMC’s plans in accordance with its second mandate – to maintain the stability of prices on a gentle upward slope – is inflation.

“Inflation matters here too,” Yellen addressed. “If we have a substantial shortfall in inflation, if inflation is persistently running below our 2 percent objective, that is a very good reason to hold the funds rate at its present range for longer.”

Thus, if inflation – currently at 1.1 percent and ranging between 1 and 2 percent since the end of 2012 – persistently remains below the Fed’s 2 percent target, there is no way the federal funds interest rate will be raised even after the monthly purchases have ended.

Not on a Preset Course

Instead of once again hanging on short little sound bites spoken by the Fed Chair, we need to remember that often repeated phrase “not on a preset course”, which has appeared in FOMC statements for years.

“Asset purchases are not on a preset course,” the latest press statement repeats, “and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.”

Interest rate hikes are not predetermined either. Even after the monthly asset purchasing program ends, and “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run,” the press release adds.

The Fed remains flexible, and is prepared to adjust both the winding down of its monthly purchases and the raising of interest rates, which Ms. Yellen made clear at yesterday’s press conference:

“If the committee [is] no longer comfortable [with] the assessments, if there is enough change in the data we’re seeing… then a case has been made to change the pace of asset purchases and to deviate from the current plan.”

To “deviate from the current plan”. Oh what a difference a few extra minutes of listening make. Neither the remainder of the monthly purchase tapering nor the raising of interest rates are written in stone, both being dependant on labor market conditions and inflation.

As investors, we need to get out of the habit of hitting the sell button on a handfull of words and get into the habit of looking at complete pictures and reading complete transcripts.

Now, it is true that the markets are jittery over multiple concerns, including geopolitical tensions in eastern Europe, slowing Chinese growth and consumption, and a hot market that looks tired and ready for a period of cooling-off. So we can’t be throwing all caution to the wind.

Yet we mustn’t panic sell either, for if the economy does take a turn for the worse, the Fed has categorically stated it remains flexible enough to alter its tapering and interest rate plans as circumstances warrant. The Fed may be letting go of toddler’s hand, but it is keeping its hands close to toddler should it begin to teeter in its steps.

Either way, the bull run remains intact, for the Fed would not be removing its helping hands if the economy were not strong enough to stand on its own.

Joseph Cafariello