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A distinctly dovish tone from Janet Yellen

"The Federal Open Markets Committee (FOMC) left the target range for the federal funds rate unchanged in January and March (2016), in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December." (2015)

"The Federal Open Markets Committee (FOMC) left the target range for the federal funds rate unchanged in January and March (2016), in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December." (2015)

- Extract from the speech 'The Outlook, Uncertainty, and Monetary Policy' given by Janet L. Yellen, chair of the Federal Reserve ('the Fed') at the Economic Club of New York on 29 March 2016

Janet Yellen gave a decidely dovish speech at the Economic Club of New York on 29 March 2016. She described readings on the US economy as "somewhat mixed" since the turn of the year and stressed downside risks. She identified the first of these downside risks as pertaining to global growth, which chair Yellen noted is "importantly influenced by developments in China." As she put it:

"There is a consensus that China's economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it. These uncertainties were heightened by market confusion earlier this year over China's exchange rate policy."

Another concern for the Fed relates to the prospects for commodity prices, particularly oil. According to Yellen the inflation outlook has also become more uncertain, partly related to the risks to the outlook for economic growth and partly due to falling inflation expectations. While core inflation has increased lately, Yellen is not convinced that this rise is sustainable.

Exhibit 1: Core PCE inflation, which strips out volatile food and energy components, was up 1.7% in February 2016 on a twelve month basis, but said Ms Yellen "it is too early to tell if this faster pace will prove durable"

Core PCE inflation

We would agree that some caution should be exercised with regard to the outlook for inflation - we see hardly any sign of inflationary pressures in the US labour market - but there are disinflationary pressures at large in the world to which the US economy is not immune. We'd also point out that although inflation data is seasonally adjusted, the pace of inflation tends to be stronger early than later in the year.

Throughout her speech Yellen underlined the message that recent developments and uncertainties call for gradual increases in interest rates. She did not of course clearly specify what precisely gradual means for the path of rate hikes. It is however clear that Yellen wants to see more stable global markets and commodity prices and does not want the US dollar to become too strong.

The question is why Yellen decided to be so dovish. At its 29 March 2016 policy meeting Fed policymakers lowered their forecasts for the trajectory of rate hikes this year and next. The median forecast fell from four rate hikes over the course of 2016 to just two. Markets anticipate even less. Fed funds futures for December trade at 0.57%, which hardly implies one rate hike (see exhibit 2 below) .

Exhibit 2: At the meeting of the FOMC on 29 March, policymakers lowered their forecasts for the path of future rate hikes. The market is pricing even fewer rate hikes (the graph shows the projections for the federal funds as published by the Federal Reserve after their meetings in December 2015 and March 2016 as well as the the trajectory for the federal funds rate based on market valuations for the federal funds futures contract).

US fed funds rate

Source: Federal Reserve, Bloomberg, BNPP IP, as at 29 March 2016

So there was no need for Yellen to seek to adjust excessively hawkish expectations in financial markets. It may of course be that she's convinced the Fed should be even more dovish than the policy projections announced at the FOMC's meeting in March. That would be a sudden change of mind so shortly after the meeting. It would seem more likely that Yellen wants to demonstrate her leadership regarding the strategy for monetary policy. Several Fed policymakers have recently argued for rate hikes, even as early as this April. While Yellen stressed that Fed policy actions are dependent on the incoming data, it is clear that she is not in favour of an early rate hike. A rate hike at the meeting on June is however still possible.

A possible difference between Yellen’s views and those of other policymakers is that Yellen may have a more global view. There is increasing evidence that inflation has become a more global phenomenon in the past decades, even in the relatively closed US economy. In her speech Yellen placed much emphasis on global developments. Looking just at the objectives in the Fed's mandate – maximum employment and price stability (interpreted by the Fed to mean a rate of inflation around 2%) - one could easily make a case for higher interest rates. However, the current level of unemployment at 5% has not sparked inflation. In a footnote to her speech, Yellen recognised that the Fed may have overestimated the longer-run rate of unemployment consistent with inflation stabilising at 2%. If, in fact, a lower rate of unemployment (than the FOMC's estimate of 4.8%) is needed to fully eliminate slack in the labour market and drive inflation back to the 2% objective, it would support Yellen’s gradual approach to rate hikes.

Our conclusion is that a rate hike in April 2016 can be virtually ruled out, but a hike in June is still possible. The path of rate hikes after June depends on the market reaction, but the possibility of only one further hike this year after June has increased.

Readings on the US economy since the start of 2016 have been somewhat mixed

As mentioned above, Yellen's view is that readings on the US economy have been "somewhat mixed."  Weakness in the manufacturing sector due to the strong US dollar and an ongoing inventory correction was confirmed by weak data on durable goods orders and shipments. Orders and shipments of durable goods both fell in February. Orders and shipments for capital goods (see exhibit 3 below), which provide a good proxy for business investment, peaked in late 2014. After a drop from that peak early in 2015 orders have moved sideways, but fell in January 2016. The weakness in shipments was less pronounced after the late-2014 peak, but has been more intense lately. Business investment in equipment and software fell in the final quarter of last year and the orders and shipments data do not suggest much improvement in the first quarter of 2016.

Exhibit 3: Orders and shipments for capital goods provide a good proxy for business investment. After peaking in late 2014 they moved sideways in 2015 before falling in January 2016 (the graph shows changes in the orders and shipments of US capital goods (excluding defense and aircraft) in USD billion, over the period between 2005 and 29 March 2016)

US capital goods

Source: Datastream; BNPP IP as at 29 March 2016.

The weakness in the manufacturing sector should to some extent be compensated by a stronger services sector and a stronger consumer sector. Thus it was helpful to see the Markit services PMI returning above 50 again in March. The drop below the boom-bust level in February looked exaggerated at the time, but the rebound was actually a bit disappointing. At 51.0 the index is still way below the average of the past two years. The ISM non-manufacturing index also improved in March, but is also clearly below the exuberant levels seen in 2014 and 2015.

The Conference Board’s measure of consumer confidence came in better than expected in March. Nonetheless the improvement still leaves it in the sideways range where it has been since late 2014. Consumers continue to be somewhat hesitant in their spending. While inflation-adjusted disposable income was up 3.8% on a 3-months annualised basis in February, real consumption was up only 1.6%. As consumers are preferring to save some of their income gains, the savings rate rose to 5.4% in February. Although this trend will weigh on growth for now, it's actually positive from a longer-term perspective. Household finances have been repaired since the financial crisis and are in better shape now than for many years. So the household sector should continue to contribute positively to growth, even though the indicators so far suggest that growth will be below trend growth in the first quarter of 2016.


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