Quick one tonight. After a succession of Fed speakers pouring cold water on the idea of further easing, Federal Reserve Vice Chair Janet Yellen opened the door for additional easing at the next FOMC meeting. Perhaps I have simply been too pessimistic in my concern that we would need to wait until later this summer. Yellen gets to the point quickly, at the end of the second paragraph:
As always, considerable uncertainty attends the outlook for both growth and inflation; events could prove either more positive or negative than what I see as the most likely outcome. That said, as I will explain, I consider the balance of risks to be tilted toward a weaker economy.
A tilt in the balance of risks to the weaker side argues for easier policy. On the labor market:
Smoothing through these fluctuations, the average pace of job creation for the year to date, as well as recent unemployment benefit claims data and other indicators, appear to be consistent with an economy expanding at only a moderate rate, close to its potential.
Obviously, we need better than potential to close the output gap – a gap that Yellen believes to exist. She clearly believes the dominant problems are cyclical, not structural. Still, she recognizes that cyclical unemployment can become structural if left unattended. Again, a reason for additional stimulus. She identifies housing, the fiscal cliff, and Europe as actual and potential drags on US economic activity. And she dismisses the idea that a large output gap is inconsistent with current inflation:
…substantial cross-country evidence suggests that, in low-inflation environments, inflation is notably less responsive to downward pressure from labor market slack than it is when inflation is elevated. In other words, the short-run Phillips curve may flatten out. One important reason for this non-linearity, in my view, is downward nominal wage rigidity–that is, the reluctance or inability of many firms to cut nominal wages.
Europe is clearly on her mind:
The deterioration of financial conditions in Europe of late, coupled with notable declines in global equity markets, also serve as a reminder that highly destabilizing outcomes cannot be ruled out.
One might think that the inner chamber at the Federal Reserve thinks their European counterparts are clueless. And they would be right. I am not impressed by this paragraph:
Of course, much of this revision in interest rate projections would likely have occurred in the absence of explicit forward guidance; given the deterioration in projections of real activity due to the unanticipated persistence of headwinds, and the continued subdued outlook for inflation, forecasters would naturally have anticipated a greater need for the FOMC to provide continued monetary accommodation. However, I believe the changes over time in the language of the FOMC statement, coupled with information provided by Chairman Bernanke and others in speeches and congressional testimony, helped the public understand better the Committee’s likely policy response given the slower-than-expected economic recovery. As a result, forecasters and market participants appear to have marked down their expectations for future short-term interest rates by more than they otherwise would have, thereby putting additional downward pressure on long-term interest rates, improving broader financial conditions, and lending support to aggregate demand.
In some sense, this is right – market participants expect that economic conditions will be such that the Fed will need to keep interest rate low for a long time. But the Fed should not be content with low rates. If policy was effective, longer term interest rates would rise in expectation of eventual Fed tightening. The collapse of rates – again – is an indication that the Fed needs to be doing much, much more. And Yellen is a dove! Note also that although expectations of additional easing seemed to set a fire underneath Wall Street today, 10-year Treasury yields gained a meager 6bp. Credit markets are not easily impressed.
Yellen concludes that the Fed has room to do more – should they want to:
If the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective, I am convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions.
Bottom Line: Of course, Yellen is just one of the committee, but an important one. And I think she would be perfectly happy to ease in this environment. The risks tilting to the downside are key. The twist is that she opened the door for additional easing via forward guidance. Market participants are really looking for something bolder, on the order of QE3. And I don’t think an extension of Operation Twist will do the trick. That has a short half-life given the Fed’s dwindling stock of short-term securities. One more caveat: Yellen, I believe, would have supported easier policy before now. What really matters is Federal Reserve Chairman Ben Bernanke. Tomorrow we learn if he follows Yellen and gives a green light for further easing.