Orlando's Outlook: Yellen walks dual-mandate tightrope at Jackson Hole



Bottom line In sharp contrast to last year’s academic snooze-fest, investors were expecting fireworks this morning when Federal Reserve Chair Janet Yellen delivered her maiden keynote speech at the central bank’s annual monetary policy conference in Jackson Hole, Wyoming. But Yellen’s remarks, in our view, struck a very cautious balance in addressing the sometimes conflicting goals of achieving both maximum employment and price stability simultaneously. As a result, we heard nothing out of Jackson Hole to alter our long-standing view that the Fed’s eventual decision to begin to raise interest rates—after it concludes the tapering of its Quantitative Easing (QE) program in October—will be data dependent, with the first hike in the federal funds rate perhaps coming in mid-2015.

Investor anticipation at Jackson Hole was high Last year, for the first time in a quarter century, the chairman of the Federal Reserve (Ben Bernanke) did not attend the Jackson Hole symposium, signaling that he would not be serving a third term as the Fed’s chairman when his term expired in January 2014. This prestigious symposium started by the Kansas City Fed in 1978 routinely draws top central bankers from around the world to discuss important global economic issues, and this year’s topic was labor-market dynamics. At this seminar in 2012, for example, in his keynote speech, Bernanke hinted at his subsequent plans for “Quantitative Easing 3,” which he then launched in September.

The monetary-policy hawks have had the public-opinion megaphone over the course of the summer, with Dallas Fed president Richard Fisher’s op-ed piece in The Wall Street Journal last month, Philadelphia Fed president Charles Plosser’s breakfast speech to investors in New York in June, and recent media interviews by Kansas City Fed president Ester George and Fed vice chair Stanley Fischer. So the expectation was that Yellen, with the eyes of the global investment community watching, would use her high-profile keynote speech to make the case for a more dovish policy balance. But she seemed to strike a more middle-of-the-road stance in her formal remarks, walking the proverbial dual-policy tightrope.

“Pragmatic” balancing act “Monetary policy ultimately must be conducted in a pragmatic manner that relies not on any particular indicator or model, but instead reflects an ongoing assessment of a wide range of information in the context of our ever-evolving understanding of the economy,” Yellen argued.

Specifically, she addressed the cyclical and structural trade-offs that have hurt employment trends over time: the retirement of aging baby boomers, the increase in discouraged workers, leaving work for school enrollment, and workers who have filed for permanent disability, because they were not happy with their job prospects. While some of these trends are permanent, some may eventually reverse when the economy and the labor market strengthens.

“Confronted with an obvious and substantial degree of slack in the labor market and significant risks of slipping into persistent below-target inflation,” she said, in defending the Fed’s aggressive monetary-policy stance over the past six years, “the need for extraordinary accommodation is unambiguous.”

Elephant in the room Ultimately, the key question on everyone’s mind is when the Fed begins to hike interest rates, and upon what triggers should investors focus?

“Tightening monetary policy as soon as inflation moves back toward two percent might prevent labor markets from recovering fully and so would not be consistent with the dual mandate,” she explained. “There is no simple recipe for appropriate policy in this context.”

So it would appear that the Yellen Fed is prepared to err on the side of higher inflation, if the trade-off is stronger labor-market traction.

In search of a one-armed economist Yellen laid out the Fed’s policy conundrum. On the one hand, she said, “if progress in the labor market continues to be more rapid than anticipated, or if inflation moves up more rapidly than anticipated, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter.”

But on the other hand, “if economic performance turns out to be disappointing and progress towards our goals proceeds more slowly than we expect, than the future path of interest rates likely would be more accommodative than we currently anticipate,” she countered.

Bottom line, Yellen concluded, “monetary policy is not on a pre-set path.” In other words, there is no change in the fact that this is still a data-dependent decision.

Mixed bag on Fed’s labor dashboard When Yellen assumed the Fed’s chair earlier this year, she took the opportunity to officially change its focus from looking at a single rate of unemployment (U-3) metric to a new employment dashboard, with a variety of key metrics. Some are performing well at present:

  • Unemployment rate (U-3) Sitting at 6.2% in July, a tick above a 6-year low, down from 10.1% at the depths of the Great Recession.
  • Net change in nonfarm payrolls Rose by 209,000 jobs in July, marking the sixth consecutive month of 200,000 or more jobs added to the economy for the first time in 17 years, with a 6-month average gain of 244,000 jobs.
  • Initial weekly jobless claims This important leading employment indicator plunged to 279,000 for the week ended July 19, which is a 15-year low.
  • Job Openings & Labor Turnover (JOLTS) This ratio monitors the abundance of new job openings and how many employees have voluntarily quit their jobs in a given month, because they have either found a new job or think they can find one quickly. Job openings in June rose to 4.67 million, which is the highest level in more than 13 years, while “quits” of 2.53 million people are at a 6-year high.

But other metrics on the Fed’s employment dashboard are languishing:

  • Wage inflation Average hourly wage growth has been stuck at a tepid 2.0% on a year-over-year basis for several months now, likely due to the abundance of available unskilled labor. The Fed would like to see this metric rise to 3% to 4% growth over time.
  • Hours worked Average weekly hours worked has been unchanged at 34.5 hours for five consecutive months through July. Every change of only 0.1 hour worked equates to an equivalent change of 350,000 full-time workers, so the Fed would love to see some overtime.
  • Labor force participation rate This metric at 62.9% is a tick above a 36-year cycle low.
  • Labor impairment rate (U-6) Considered the true unemployment rate, because it takes the U-3 and adds back discouraged and underemployment workers. This metric has fallen from 17.4% in October 2009 to 12.2% in July 2014. But the Fed would like to see it down around 7-8% to consider the labor market healthy.

Inflation cover But the Fed still has some room to maneuver while waiting for the labor market to recover, because the key inflation metrics that Yellen monitors are still relatively well behaved. In fact, a rise in inflationary pressures earlier this year has recently receded, lending credence to Yellen’s thesis that the spike was just “noise.”

  • Producer Price Index (PPI) On a year-over-year basis, core wholesale inflation (which strips out volatile food and energy prices) troughed at a very well-behaved 1.1% in February. But over the next three months, core PPI levels rose to 2.0% in May, although they have since backed off to 1.6% in July.
  • Consumer Price Index (CPI) Also on a year-over-year basis, core retail inflation troughed at 1.6% in February, rising to 2.0% in May, although it receded to 1.9% in both June and July.
  • Personal Consumption Expenditure (PCE) On a year-over-year basis, the core PCE index—the Federal Reserve’s preferred measure of inflation—also bottomed at a very benign 1.1% in February, which was near the low end of the Fed’s 1.0% to 2.0% target range and well below its 2.0% inflation trigger to reverse its current Zero Interest-Rate Policy (ZIRP). More recently, core PCE levels have risen to 1.5% in both May and June. The Fed expects CPI to be roughly 0.5% higher than PCE.

Commodity prices fall The recent decline in both agricultural and oil commodity prices will reduce nominal inflation pressure near-term, and may have some longer-term core inflation benefits.

  • Ag prices plummet Over the past four months, due to excellent growing conditions, corn and wheat prices plunged by 30% to about $3.70 and $5.60 per bushel, respectively, while soybeans have fallen by 20% to $10.40 per bushel.
  • Crude oil prices fall Due to a diminution of geopolitical risks, particularly in Russia, Iran, Syria, Israel and Iraq, West Texas Intermediate (WTI) prices have dropped by about 12% over the past two months, to about $93 per 42-gallon barrel of oil.