Three things we learned from Janet Yellen’s testimony last week

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If you thought that the Fed will continue to hike interest rates, or wondered why the U.S. dollar has been sinking for the most part this year, then Janet Yellen’s testimony gave all the hints the markets needed.

Contrary to the prevailing idea that the Fed could be looking at hiking interest rates one more time this year, Ms. Yellen’s testimony showed the markets that the Fed was thinking on the contrary.

Here are the three things that we learned this week from Ms. Yellen’s semi-annual testimony to the U.S. Congress which began on Wednesday and concluded on Thursday last week.

1. Interest rates and balance sheet

The Fed Chair told U.S. lawmakers that while the Fed will go ahead with its plans to shrink its balance sheet, the same was not true with interest rate tightening. The Fed’s short term fed funds interest rate sits at 1.0% – 1.25%. The Fed had previously signaled that there could be one more rate hike this year.

However, Ms. Yellen echoed similar views from another FOMC Governor, Lael Brainard. The theme was that despite inflationary pressures being doubtful, the Fed intends to normalize the balance sheet. Expectations are that this could start as early as September at a pace of $10 billion per month.

The Fed’s balance sheet ballooned to $4.5 trillion as it purchased Treasuries and agency mortgage backed securities or MBS.

We also learned that interest rates were close to a “neutral level” and thus not in need of further increases.

The neutral rate is a level where interest rates or the Fed’s short term rate does nothing to either boost or to hold back the economy.

The real rates, which is a measure of both inflation and the fed funds rate is near zero. The short term Fed funds rate currently stands at 1% and 1.25%, while inflation was around 1.4%. Although the neutral rate is near zero, the case for further rate hikes remains questionable.

An appropriate timeline was given for balance sheet normalization, which could take up to the year 2020.

“We’ve not decided yet on what our longer-run monetary policy framework will be,” Ms. Yellen said during the congressional testimony.

2. Inflation concerns

Ms. Yellen told lawmakers “We’re watching this very closely and stand ready to adjust our policy if it appears that the inflation undershoot will be persistent.”

She was optimistic that the current labor market conditions will help to eventually put pressure on wages and in turn inflation.

Last week, the U.S. producer prices index showed a modest uptick in inflation at the factory gate but it was nothing worth notable. The data suggested that price pressures continued to stay subdued. While some members of the FOMC did express concern that inflation will overshoot the 2% target rate, that scenario is starting to look increasingly unlikely.

On Friday, the U.S. consumer prices index data showed that headline CPI was flat for the month, while core CPI rose just 0.1%, slower than the 0.2% increase registered the month before.

3. Yellen’s term as the Fed Chief

This received less coverage, but the fact is that the Fed chair’s tenure as the chief of the world’s most powerful central bank will end in February 2018. It is common knowledge that the U.S. President Trump and the Fed Chair Yellen differ in their views on almost everything.

Trump made his displeasure of Yellen clear during his campaign trail where he said that he would prefer to put someone else as the head of the Federal Reserve.

When questioned about whether this was going to be the last time in front of the congressional committee, Ms. Yellen replied that while she intends to serve her full term which ends next year, it “might well be” her last.

While it is still too early to tell, a name that is making the rounds already is Gary Cohn. Cohn currently serves as the National Economic Council Director. Although Cohn has downplayed the speculation, his appointment as the Fed chair will be a first as he would potentially become the first Fed Chair who is not an economist.

Cohn was previously working at Goldman Sachs’ investment division. Support for Cohn is already ratcheting up especially from Wall Street.

The U.S. dollar remained weak as a result and it is likely that the dovish tightening cycle could hit the sentiment in the greenback even further. This especially comes at a time when central bank officials elsewhere are looking at a hawkish tightening cycle.

Just last week, the Bank of Canada became the second G7 central bank to hike interest rates by 25 basis points and another rate hike is also expected.

However, all is not lost as the Fed’s policies are quite data dependent. Furthermore, the balance sheet normalization itself is a form of policy tightening. For the moment, the U.S. economic data will play a key role. Any signs of pick up in the economy could however see the Fed push ahead with its original plans for another rate hike this year.


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