Looking to Yellen for Clarity Amid Fed’s Mixed Messages

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Fed governors at odds
The US stock market rally lost momentum last week with stocks finishing relatively flat. Interestingly, stocks decoupled from oil prices, which continued their multi-week move higher. The minutes from the July FOMC meeting were also released last week, and expectations of a September rate hike went down despite somewhat hawkish words from New York Fed President William Dudley.

But then came Fed Vice Chair Stanley Fischer’s speech on Sunday at the Aspen Institute. Fischer's speech covered a wide range of topics, including his view that the US economy is close to reaching both Fed mandates on employment and inflation. Some may be skeptical that the Fed is anywhere near its inflation target, but Fischer asserted that core inflation is “within hailing distance” of its target.

Fischer clearly does not speak for all FOMC participants; in the July FOMC meeting minutes, several participants “viewed the risks to their inflation forecasts as weighted to the downside, particularly in light of the still-low level of measures of longer-run inflation expectations and compensation and the likelihood that disinflationary pressures from abroad would persist.”

The limitations of monetary policy
However, consider the most recent Consumer Price Index (CPI) print, which was released last week. While the CPI came in unchanged for July, weighed on by weakness in energy and transportation prices, inflation is likely to increase later this year. There are a variety of reasons for this, including base effects, and that energy and transportation are volatile components which can change direction on a dime. In addition, while both medical care and housing costs have already experienced significant price inflation recently, they appear poised to increase even further. The latter explains much of the increase in core service price inflation that continues to run at over 3% year-over-year.

Vice Chair Fischer covered other topics, including disappointing productivity, and explored the possible causes. He also addressed the view that many market participants expect the neutral interest rate—defined as the rate at which economic growth neither increases nor decreases—to be lower than the historical neutral rate.

Perhaps most importantly, Fischer echoed the recent words of other Fed officials in underscoring the limitations of monetary policy, explaining that “monetary policy is not well equipped to address long-term issues like the slowdown in productivity growth. Rather, the key to boosting productivity growth, and the long-run potential of the economy, is more likely to be found in effective fiscal and regulatory policies.” Fischer’s policy prescription is a combination of infrastructure spending, education spending, private investment and better regulation.

A Fed hike by year end?
Vice Chair Fischer also gave a relatively positive assessment of the US economy, recognizing its resilience and sharing his expectation that GDP growth will increase in coming quarters as investment improves. The overall takeaway from Fischer's words is that the Fed may very well raise rates soon. It seems that the market was listening, as the dollar rose relative to other currencies.

While it’s more likely that the Fed will raise rates in December rather than September, we stress that we believe a September rate hike remains a possibility. If the data make the case for a rate hike, we don’t think the presidential election will necessarily stop the Fed from moving. However, we'll get far more insight into what the Fed is thinking in a few short days, when Chair Yellen is scheduled to speak at the Kansas City Fed’s symposium in Jackson Hole. Chair Yellen may use this opportunity to foreshadow a September rate hike—which in turn could result in significant swings in currency values.

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About the Author
Kristina Hooper is the US Investment Strategist and Head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Important Information
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.

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