Orlando's Outlook: Yellen avoids Jackson Hole policy discussion

08-25-2017

Bottom line The S&P 500 has corrected by some 3% over the past several weeks, as investors have grappled with myriad market risks, among them poor seasonality, an earnings hangover from a solid second-quarter reporting season, geopolitical fears, ongoing chaos in Washington and an impending debt-ceiling crisis in Congress. Add to the list Federal Reserve uncertainty, both in terms of monetary policy and leadership transition.  

We had hoped that Fed Chair Janet Yellen would use her keynote speech this morning at the Fed’s annual monetary policy conference in Jackson Hole, Wyo., to address key investor questions, such as the timing and pace of shrinking the Fed’s $4.5 trillion balance sheet and additional interest-rate hikes. Instead, she devoted her formal remarks to discussing the need to retain heightened levels of financial regulation, which had been established in the aftermath of the Great Recession. As a result, her speech raised additional questions about leadership transition when her term as Fed chair expires next February.

Why is Jackson Hole important? This prestigious monetary-policy symposium, which was started by the Kansas City Federal Reserve in 1978, routinely draws top central bankers from around the world to discuss important global economic issues. This year’s theme is “Fostering a Dynamic Global Recovery.”

The current Fed chair typically enjoys a high-profile keynote speaking slot to discuss important monetary-policy thoughts and plans. In past years, for example, then Fed Chairman Ben Bernanke discussed his plans for “Quantitative Easing 3,” while European Central Bank (ECB) President Mario Draghi outlined his own plans for European QE at a subsequent conference. This year, Yellen’s speech was entitled “Financial Stability a Decade after the Onset of the Crisis,” and she delivered a more academic (rather than policy-oriented) address, which largely supported the federal government’s increased regulatory footprint. 

What were the key points in Yellen’s speech? It appears to us that if this was, indeed, Yellen’s last speech at Jackson Hole as the Fed chair, she wanted to leave a clear message to preserve the core of post-crisis financial regulation. 

“Financial institutions had assumed too much risk, especially related to the housing market, through mortgage lending standards that were far too lax and contributed to substantial overborrowing,” she said this morning. “The evidence shows that reforms since the crisis have made the financial system substantially safer.

“The events of the crisis demanded action, needed reforms were implemented, and these reforms have made the system safer,” Yellen added. “Now—a decade from the onset of the crisis … a new question is being asked: Have reforms gone too far … to support prudent risk-taking and economic growth?”

While Yellen conceded there may be benefits to simplifying aspects of the Volker rule, which limits proprietary trading by banks, she added that any adjustments to the regulatory framework should be modest.

“The balance of research suggests that the core reforms we have put in place have substantially boosted resilience without unduly limiting credit availability or economic growth,” she said.

“We can never be sure that new crises will not occur,” she concluded, “but if we keep this lesson fresh in our memories—along with the painful cost that was exacted by the recent crisis—and act accordingly, we have reason to hope that the financial system and economy will experience fewer crises and recover from any future crisis more quickly.”

So why is this a problem? President Trump does not appear to have any problems with the dovish Fed chair’s views on monetary policy issues, as lower interest rates and a weaker U.S. dollar have actually helped to support stronger economic and corporate earnings growth and higher equity prices. But the regulatory theme on which Yellen harped this morning could be a potential burr in Trump’s saddle. Trump has long felt that regulatory overreach by President Obama contributed to a slower-than-normal economic rebound from the Great Recession. Consequently, we believe that Trump would prefer to reset the regulatory pendulum back towards the center. As such, this could be the final hurdle that Trump can’t successfully leap to renominate Yellen to a second term, which spotlights the potential for leadership transition risk at the Federal Reserve. (Please see our Aug. 8 Orlando’s Outlook on this subject, “Is Fed’s leadership transition a market risk?”)

Monetary policies clues In the midst of her speech on regulation, Yellen did slip in a subtle plug for the improved health of the Fed’s dual mandate, when she said that “substantial progress has been made toward the Federal Reserve’s economic objectives of maximum employment and price stability.” In our view, that justification kept in place the Fed’s unspoken plans to begin to shrink its $4.5 trillion balance sheet and hike interest rates by another quarter point later this year.

Balance-sheet shrinkage plans Because Yellen chose not to discuss her thoughts on this issue this morning, the market’s focus shifts to the Fed’s next policy-setting meeting on Sept. 19-20. This meeting also has a press conference to follow, which would allow Yellen to further explain and detail the Fed’s thinking during her question-and-answer session with financial journalists. So it’s possible that the Fed could pull the trigger to get the ball rolling in September, and it’s equally plausible that the Fed could outline what it plans to do, with the first steps taken at its next meeting on Halloween.

At present, the Fed’s balance sheet totals about $4.5 trillion, comprised of about $2.8 trillion in Treasuries and $1.7 trillion in mortgage-backed securities (MBS). Our best guess is that in September or October, the Fed will begin to allow a monthly cap of about $6 billion in Treasuries and about $4 billion in MBS to mature and slowly roll off the balance sheet. The cap system could then increase by about $5 billion or so each quarter in both asset classes, reaching a maximum level of about $30 billion in monthly maturities in each.

The Fed’s longer-term 5-year plan would be for the current $4.5 trillion balance sheet to gradually shrink to about $2.5-3 trillion, which it will establish as its new normal, with a focus on eventually reducing the MBS side of the balance sheet to zero over time. We do not envision the Fed returning to a pre-Great Recession sub-$1 trillion balance sheet.

Interest rates The core personal consumption expenditures (PCE) index—the Fed’s preferred measure of inflation—was running at a 1.5% year-over-year rate in May and June, but that’s down from 1.9% in both January and February, and still well below the Fed’s aspirational 2% inflation target. The July reading, which will be flashed on Aug. 31, is expected to tick down to only 1.4%. So the Fed, in our view, is trying to buy itself time in the interim by focusing on balance-sheet shrinkage in September and October, and waiting until December potentially to orchestrate its next quarter-point hike in the fed funds target rate. That would be its fifth rate hike this cycle.

While the Fed believes that lagging inflation data is transitory, based upon lower cell-phone bills, we believe that the problem is more structural, due to imbalances in the labor market and the wider price-inhibiting use of technology.

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