Observations on Yellen's Speech Yesterday

In light of Yellen’s speech yesterday on Inflation Dynamics and Monetary Policy, I thought I’d offer a few comments that I believe are receiving insufficient attention in the financial press.

First, when asked at last week’s press conference about the timing of the anticipated rate hike, Yellen noted that "most [FOMC] participants continued to think that economic conditions will call for or make appropriate an increase in the federal funds rate by the end of this year" – a view she reiterated in her comments yesterday. But if she had been asked at the press conference for the date she expected financial conditions to tighten, she would have answered, ‘They just did.’ More precisely, in her introductory remarks at the press conference she said, "Developments since our July meeting—including the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads—have tightened overall financial conditions to some extent. These developments may restrain U.S. economic activity somewhat and are likely to put further downward pressure on inflation in the near term." This perceived tightening of financial conditions weakened the argument for a hike at this month’s meeting, and we should expect FOMC members to incorporate their perceptions of subsequent financial conditions as they consider policy options at the October and December meetings.

Second, some FOMC members may be more comfortable raising rates once they have greater confidence in the technical capabilities of their new policy tools to ensure that money market rates in general increase with the IOER. In particular, the Fed’s open market desk is running term repo programs across the Q3 and Q4 quarter-ends at the instruction of the FOMC "…to examine how term RRP operations might work as an additional supplementary tool to help control the federal funds rate." I don’t mean to overemphasize the importance of this factor in their deliberations, but it’s worth keeping in mind that their decision to announce a policy change depends not only on their intentions but also on their perceived capabilities.

Third, in her speech yesterday, Yellen offered her perspective on factors that produce short-term departures of inflation from longer-term expectations. "Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy…" However, she neglected to specify whether “the economy” to which she referred is the US economy, the global economy, or perhaps some subset of the global economy. The considerable correlation between inflation rates in the larger economies suggests resource slack globally is a relevant consideration, with two specific implications. First, it’s not merely slack in the US labor market that is relevant. Slack in foreign labor markets has a direct effect on US labor costs in the markets for tradeable goods and services, as well as an indirect effect on US labor costs in the nontradeable sector, via competition for labor between firms in the tradeables and nontradeables sectors. Second, underutilization of the stock of physical capital globally is also relevant, which is particularly important given ongoing upward revisions in estimates of the amount of underutilized capital stock in China after years of record investment.

Fourth, in her speech yesterday, Yellen argued, "the presence of well-anchored inflation expectations greatly enhances a central bank's ability to pursue both of its objectives--namely, price stability and full employment," since a flat expectations-augmented Phillips curve implies that a large change in employment results in only a small change in inflation. But a high sacrifice ratio also means that a large increase in employment would be required to result in a modest increase in the inflation rate. In forecasting a return of inflation to its 2% target over a reasonable horizon, Yellen is relying on inflation expectations being anchored close to 2%. But as she notes, market-based measures of inflation expectations have declined, with the five-year breakeven rate at 1.11%, now 60 bp off this year’s high; 70 bp below its five-year average; and 89 bp below the Fed’s 2% reference rate. Yellen suggests that the market-based measures may be biased by changes in liquidity and in risk premiums, but she’s aware of the risk that market participants are coming to view below-target inflation as persistent. If the FOMC were confronted with a flat Phillips curve anchored below 2%, even the “gradual pace of tightening” anticipated by most FOMC members would be inconsistent with the return of inflation to target over a relevant policy horizon.

Yellen and her colleagues on the FOMC insist on setting policy appropriate for the US economy rather than for the global economy more generally. But given the interconnectedness of major economies, the FOMC is forced to consider developments outside the US. And given inflation developments in the Eurozone, Japan, the UK, and even China – and given estimates of resource slack in these economies – FOMC members are unlikely to make much progress toward even a modest ‘normalization’ in the next few quarters. And for similar reasons, if Yellen is correct that the Phillips curve is relatively flat, the labor and capital markets globally are likely to have a greater influence in the next few quarters on real rates, inflation, and output developments in the US than will Fed policy.