Fed's Janet Yellen Does An About-Face On Interest Rates
IN THIS ISSUE:
1. US Economy Off to a Terrible Start So Far in 2016
2. Fed’s Yellen Reverses Course on US Interest Rate Hikes
3. Yellen Silences the Hawks in New York Speech Last Week
4. Rising Inflation Could Force Yellen’s Hand Just Ahead
On Tuesday of last week, Fed Chair Janet Yellen delivered a surprising speech at the Economic Club of New York. Back in December, the Fed raised short-term interest rates for the first time in over eight years and told us to expect four more hikes in the Fed Funds rate in 2016.
Yet in her speech last week, Ms. Yellen offered a very different outlook for interest rates, suggesting there may be only one – or even no – interest rate hike this year. She cited increased concerns about the global economy. So what gives? That’s what we’ll talk about today.
As a part of that discussion, we’ll look at the current breakdown of Fed policy committee members and specifically the number of members who want to see interest rate hikes sooner than later – the so-called “hawks” – versus those who prefer to defer interest rate hikes – the so-called “doves.”
Before we get to the Fed, let’s look at how the US economy is doing so far this year. The answer is that the US economy is off to a terrible start in 2016. The latest forecast from the Atlanta Fed has US GDP growing at the anemic rate of only 0.7% in the 1Q, well below expectations and well below the near 2.0% growth in 2015.
Fortunately, not all of the economic news of late was bad. Last Friday’s unemployment report for March was better than expected with 215,000 new jobs created. Wages came in better than expected as well. Let’s take a look.
US Economy Off to a Terrible Start So Far in 2016
As I reported in my E-Letter last Tuesday, the US economy grew by only 1.975% for all of 2015 versus 2.4% in 2014. Based on the weekly GDPNow report, the Fed sees the economy slowing sharply so far this year, growing by only 0.7% (annual rate) in the 1Q as of the end of last week. That’s way down from a reading well above 2.5% in early February. Something unexpected has been happening since late last year and it’s definitely not good.
For the last several years, many forecasters have been predicting that each New Year would be a breakout year for the US economy. It hasn’t happened.
GDP was up apprx. 2% in 2015, 2.4% in 2014 and 1.5% in 2013. That’s an average of just under 2.0%. Some economists are now suggesting that 2% economic growth is the “New Normal.”
As an aside, you may recall that last week’s E-Letter focused on the gross inaccuracies of the Fed’s GDP estimates and forecasts over the years. I should point out that the GDPNow report is produced independently by the Atlanta Federal Reserve Bank using very different methodology than that employed by the Fed itself.
GDPNow was launched in 2014, and so far it has proven to be much more accurate than the economic projections from the Fed itself. For example, the Fed projects GDP growth of 2.2% for all of 2016, but as you can see above, that looks awfully optimistic based on the GDPNow forecast of only 0.7% for the 1Q.
Moving on, fortunately not all the economic news of late has been bad. Last Friday’s unemployment report for March came in slightly better than expected. The Labor Department reported that 215,000 net new jobs were created in March. The March report capped the best two-year period for hiring since the late 1990s.
The headline unemployment number rose from 4.9% to 5.0% because more people are returning to the workforce. The Labor Force Participation Rate rose for the third consecutive month. And wages rose a better than expected 0.3% last month and were up 2.3% from a year ago. All in all, it was another strong jobs report.
Fed’s Yellen Reverses Course on US Interest Rate Hikes
As we all know, the Fed initiated its first rate hike in eight years on December 16 following the final policy meeting of last year. That action took the Fed Funds rate from 0.00%-0.25% up to 0.25%-0.50% in what was widely referred to as “lift-off.”
At that same time, the Fed let it be known that it intended to raise the Fed Funds rate range four additional times in 2016, presumably at the March, June, September and December meetings of the Fed Open Market Committee (FOMC).
The initial rate hike and the forward guidance regarding additional increases in 2016 were widely expected well ahead of the announcement on December 16, and the US stock markets seemed to take the news in stride as we edged toward the Christmas and New Year’s holidays.
Yet as we awoke on Monday, January 4 we learned that equity markets around the world were sharply lower, and our markets were set to follow suit. Stocks around the world continued sharply lower for the next three weeks. The Dow and the S&P 500 plunged about 12% while many equity markets around the world declined significantly more.
The main culprit was the Fed’s rate hikes planned for 2016. Many around the world voiced concerns that these rate hikes would drive the US dollar higher and harm economies around the world, especially those emerging nations that have a lot of dollar-denominated debt. Serious concerns arose that we might be facing another financial crisis.
Fast forward to the March 15-16 FOMC meeting when the Committee’s policy statement acknowledged that global financial conditions "pose risks.” As a result, the FOMC voted not to hike the Fed Funds rate, which was widely expected.
In her post-meeting press conference, Fed Chair Janet Yellen let it be known that the Committee had also discussed reducing the number of rate hikes in 2016 from four to only two instead. Equity markets which had already begun to recover accelerated more to the upside on the assumption that the Fed would not raise rates again until at least the June policy meeting.
Several of the more hawkish members of the FOMC felt the need to speak out publicly to say that they believe the Fed Funds rate should be raised sooner rather than later. At least one voting member of the Committee suggested that the next rate hike could come as early as the April 26-27 policy meeting.
Yellen Silences the Hawks in New York Speech Last Week
We will never know if the hawks and their recent public comments irritated Ms. Yellen or not, but her speech in New York last week made it clear that she is in no hurry to raise the Fed Funds rate anytime soon. In fact, she suggested that there may only be one rate hike in 2016 if at all.
Yellen delivered an eye-opening speech last Tuesday at the Economic Club of New York. She emphasized to the liberal/dovish crowd that the Fed will move cautiously as it considers any further rate hikes. She emphasized that the global economic and financial situation has clearly worsened since December when the Fed suggested four rate hikes in 2016.
Not only did Yellen warn about global risks, she emphasized the possibility that they could get worse before they get better. For this reason, apparently, the Fed Chair hinted that there might be only one interest rate hike in 2016 or even none at all.
She responded to one question by saying it is not out of the question that the Fed Funds rate range could belowered back to 0.00%-0.25% if necessary. She stated:
“By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.”
No one has been talking about cutting the Fed Funds rate back to near zero, so this was clearly a message from Yellen to the hawks on the FOMC as a reminder that she is still in charge. And she is, at least for now.
Of the 19 total members of the FOMC, only four are widely considered to be hawks. They include Esther George, Kansas City Fed President, Loretta Mester, Cleveland Fed President, James Bullard, St. Louis Fed President and Jeffrey Lacker (my personal favorite), Richmond Fed President.
The current 12 voting members of the FOMC include only Esther George, Loretta Mester and James Bullard; Jeffrey Lacker is not a voting member this year. I mention this only to make the point that Janet Yellen and the other doves on the Committee greatly outnumber the hawks.
As long as the doves outweigh the hawks, Yellen’s vote is really the only one that matters when it comes to policy decisions. And she made it abundantly clear last week that she has no intention of raising the Fed Funds rate anytime soon.
Most Fed watchers are now speculating that there will only be one rate hike this year and that it likely won’t happen until December. We’ll see about that.
Rising Inflation Could Force Yellen’s Hand Just Ahead
While it is clear that Chair Yellen does not want to raise rates anytime soon, the continued rise in inflation may become a problem that forces her to change her mind. The Fed says it wants to see inflation rise back to the 2% level, and one popular inflation index has already surpassed that level.
As I have pointed out often over the years, the Fed’s favorite indicator of inflation is the “core” Personal Consumption Expenditures Index (PCE), which excludes food and energy. The more widely followed gauge of inflation is the Labor Department’s Consumer Price Index (CPI). As I reported last month, core CPI rose to 2.3% in the 12 months ended February.
The core PCE Index rose only 1.7% over the 12 months ended February. As you can see in the chart below, both indexes are clearly trending higher, and it may not be long before the core PCE Index is above 2% as well.
If core PCE rises above 2%, the Fed’s chosen target, then some of the current doves on the FOMC will begin to argue for hikes in the Fed Funds rate along with the current voting hawks on the Committee.
Since Ms. Yellen’s dovish comments last week in New York, some Fed watchers have argued that she is making a risky gamble on inflation by delaying a second rise in the Fed Funds rate indefinitely. Yellen admitted last week that core PCE is higher than the Fed anticipated back in December. She also admitted last week that the Fed Funds rate is currently 1.25% below its “neutral” level (ie – a normal rate environment).
A chorus of critics have warned that the Fed is falling behind the curve as the labor market tightens and commodity prices start to firm again, fearing a repeat of the 1970s when the institution repeatedly found excuses to delay taking action on the grounds that there was still plenty of hidden slack in the economy.
In fact, the split among the doves is already starting. After Yellen’s speech last week San Francisco Fed President John Williams, normally a dove, warned that the US labor market is tighter than it looks and that underlying inflation is building up.
So it will be very interesting to see whether core inflation will continue to heat up, and if it does, how this plays out within the Fed. I will keep you posted as always.
All the best,
Gary D. Halbert