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Between The Lines Of Yellen’s Speech—–Do You Really Need Us?

Summary:
In case you need any assistance in trying to figure out when Janet Yellen spoke, or at least when the text of her speech was released from embargo, here is a hint: It seems her stream of consciousness was somewhat consistent with the old Greenspan idea of “fedspeak.” People and investors appear to have taken from it what they wished, with some commentary talking about its apparent “hawkishness” before being overwhelmed by others claiming its clear “dovishness.” I don’t think either of those terms apply, and certainly not in the fashion with which they are leveled by the continued conventions of mainstream perspective about monetary policy. What I found in the speech is some good indication for what I wrote yesterday, though you as the reader should be equally suspicious about whether I am falling into that same fedspeak trap (as I so very much look forward to the day when nobody cares one bit what any Fed official or central banker has to say, and that day is coming). Yellen’s speech, in my estimation, contained perhaps a bit more softening in terms of the certainty with which so much has been taken for granted for so many years. It isn’t a whole lot, nor should we expect the Fed or any of its officials to radically alter their public views in condensed fashion. Reading between enough lines, the questioning is palpable.

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In case you need any assistance in trying to figure out when Janet Yellen spoke, or at least when the text of her speech was released from embargo, here is a hint:

ABOOK August 2016 Yellen Speech JPY

It seems her stream of consciousness was somewhat consistent with the old Greenspan idea of “fedspeak.” People and investors appear to have taken from it what they wished, with some commentary talking about its apparent “hawkishness” before being overwhelmed by others claiming its clear “dovishness.” I don’t think either of those terms apply, and certainly not in the fashion with which they are leveled by the continued conventions of mainstream perspective about monetary policy.

What I found in the speech is some good indication for what I wrote yesterday, though you as the reader should be equally suspicious about whether I am falling into that same fedspeak trap (as I so very much look forward to the day when nobody cares one bit what any Fed official or central banker has to say, and that day is coming).

Yellen’s speech, in my estimation, contained perhaps a bit more softening in terms of the certainty with which so much has been taken for granted for so many years. It isn’t a whole lot, nor should we expect the Fed or any of its officials to radically alter their public views in condensed fashion. Reading between enough lines, the questioning is palpable. As WSJ’s Jon Hilsenrath wrote yesterday, “…after more than a decade of economic disappointment, the central bank confronts hardened public skepticism and growing self-doubt about its own understanding of how the U.S. economy works.” I would classify that, in perhaps a minor key, as Yellen’s theme.

Reading through her thoughts, it does appear at first that nothing has changed. The current Fed Chair talks about how the current condition may contribute to monetary difficulties in the future should the Fed need to address another downturn (I won’t use the term recession because I don’t believe it applies, a fact that continued intellectual growth in economics should accept eventually). And so she poses all the usual remedies and all the usual suggestions about how the staff has modeled just how much “accommodation” the economy would need entering such a situation.

In part, current expectations for a low future federal funds rate reflect the FOMC’s success in stabilizing inflation at around 2 percent–a rate much lower than rates that prevailed during the 1970s and 1980s. Another key factor is the marked decline over the past decade, both here and abroad, in the long-run neutral real rate of interest–that is, the inflation-adjusted short-term interest rate consistent with keeping output at its potential on average over time…

Would an average federal funds rate of about 3 percent impair the Fed’s ability to fight recessions? Based on the FOMC’s behavior in past recessions, one might think that such a low interest rate could substantially impair policy effectiveness…

A recent paper takes a different approach to assessing the FOMC’s ability to respond to future recessions by using simulations of the FRB/US model… In general, the study concludes that, even if the average level of the federal funds rate in the future is only 3 percent, these new tools should be sufficient unless the recession were to be unusually severe and persistent.

Again, it sounds like the usual mumbo jumbo that had so very little impact the last time around. The paper she references maps out a statistical likelihood of aggressive policy response that would be effective if combined with $2 trillion in “asset purchases” (is the term QE sufficiently poisoned?) and forward guidance about sustained “lower for longer.” Had this speech been given by former Fed Chair Ben Bernanke there is little doubt the discussion would have ended there; maybe even Yellen from last year, too.

Instead, she follows by admitting, “Of course, this analysis could be too optimistic. For one, the FRB/US simulations may overstate the effectiveness of forward guidance and asset purchases, particularly in an environment where long-term interest rates are also likely to be unusually low.” That is, of course, the most stinging criticism of monetary policy, the continued over-estimation of pretty much everything they have done. She then makes two further points that in my view add new cloudiness in the otherwise surface continuity.

Her speech here in turning toward reservations references a paper written by Hess Chung, Principal Economist for the Federal Reserve Board. Chung examined the modeled effectiveness of forward guidance, not the real world outcomes of it, but what it “should” be given the standard orthodox assumptions (neo-Keynesian). Since the customary models all assume forward guidance effective, this was an especially charitable test for the procedure. But he found no conclusive results:

Despite this common core, the models differ, sometimes substantially, on a number of dimensions, including the exact modeling of household and firm decisions and the data sample used to estimate key behavioral parameters. While results from simulations of conventional (unanticipated) monetary policy shocks do differ somewhat across models, simulations involving forward guidance about future policy actions exhibit much greater divergence.

In short, this paper, which Janet Yellen specifically highlighted, suggests that the Fed’s own various models aren’t at all sure what forward guidance might actually accomplish. Since economists only speak in regressions and models, it is, again in my view, a very telling inclusion in her speech (especially as, it should be noted, the paper was published a year and a half ago in February 2015).

As noted above, her speech was throughout preoccupied with the very real possibility that interest rates might not ever recover. That is a marked difference from not all that long ago when “transitory” was still the operative theory. In trying to explain how and why that might be, Yellen mostly defers, bringing up factors like weak productivity, structurally lower inflation (so much for “transitory”), demographics, the low natural rate of interest, and even a possible “decreased propensity to spend in the wake of financial crises around the world” as if that didn’t suggest anything about the job central bankers in general have been doing. In other words, she is left to just throw a number of things against the wall because she really doesn’t know and even says so:

Although these factors may help explain why bond yields have fallen to such low levels here and abroad, our understanding of the forces driving long-run trends in interest rates is nevertheless limited, and thus all predictions in this area are highly uncertain.

It is quite far from the interest rate fallacy or admitting the bond market riddle isn’t actually a riddle, but coming from where economists have been it is perhaps much closer than anything we have seen in years, if ever.

In the usual closing, Chairman Yellen expresses all the expected confidence that these tools despite uncertainties will be effective, but what else would she say at this point?

Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed’s policy toolkit. In addition, it is critical that the Federal Reserve and other supervisory agencies continue to do all they can to ensure a strong and resilient financial system. That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.

We have gone from interest rate targeting to emergency or extraordinary policies to quantitative easing and now “explore additional options.” It is not “we really don’t know what we are doing” but it is in my mind moving in that direction, if very slowly. The clock is ticking, however, while we are supposed to wait for economists and policymakers to save enough face while passively admitting what so many people figured out years ago. How much more time beyond the (at least) nine years are we supposed to let them just investigate further options apparently at their leisure, and further why should we have even the slightest faith that anything they “figure out” will be any different?

That is not what might truly be the positive signal here, if indeed it is not the product of my own bias. The Fed’s credibility is damaged and if enough people get the sense that even the Fed is thinking that way it could open the door to actual reform, loosening the once impenetrable grip that the “Greenspan put” had placed via myth on the global economy. After all, if a decade of arrogance and unearned confidence delivers nothing more than “explore additional options” then it truly wouldn’t be much of a leap to “what do we need these guys for?”

Jeffrey P. Snider
As Head of Global Investment Research for Alhambra Investment Partners, Jeff spearheads the investment research efforts while providing close contact to Alhambra’s client base.

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