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 Wednesday 27 September 2017

What is the Fed trying to tell us? - PM Bulletin

 

 

The Fed Chair even went further saying the central bank may misunderstand “the fundamental forces driving inflation."

The dollar has continued to rally today with the EURUSD dropping further below 1.1800. The greenback’s recovery has been helped by a speech last night from US Federal Reserve Chair Janet Yellen, and comes ahead of President Trump’s tax plan due to be unveiled today. Mr Trump is expected to announce details of tax cuts for corporations and for middle and low income households. Whether his plans will pass through Congress unchanged is another matter altogether.

Turning to Janet Yellen, overall her speech and subsequent answers to questions were interpreted as hawkish by the markets. But this wasn’t a straightforward read, and a number of prominent commentators considered it quite dovish. One of the most notable moments of her appearance was when she admitted that the Fed may have overstated the strength of the labour market and got its inflation forecasts wrong. The Fed Chair even went further saying the central bank may misunderstand “the fundamental forces driving inflation.” She also said the FOMC shouldn’t wait for inflation to hit 2% before raising rates and that moving gradually could be risky. But Dr Yellen tempered this thought by saying the Fed may need to slow the removal of accommodation should the economic data show signs of weakening.

Dr Yellen made some interesting observations concerning the Fed’s forecasts and specifically about the FOMC’s “dot plot” in the Q&A session which followed her speech. She emphasised the “downsides to predictability” citing the many surprises that can affect the economy. She also said that nothing could be set in stone, citing the facts that that the Fed, together with other economists had, over the years, revised down the equilibrium real rate of interest along with the sustainable rate of unemployment. This suggested that there wasn’t a great deal more tightening to come while a gradual approach was correct. She also harked back to the Fed’s first rate hike in this current cycle. Dr Yellen pointed out that the FOMC’s December 2015 “dot plot” forecast was too hawkish. The committee forecast four hikes in the following year but ended up raising rates just one more time.

These comments must cast some doubt over the potential accuracy of the FOMC’s latest “dot plot” which was released last week. The current forecast suggests that the Fed is prepared to raise rates by 25 basis points in December and by a further 75 basis points over the course of 2018. If so then the fed funds rate could be in the 2.00/2.25% band by the end of next year. This would be interesting as just last week Dallas Fed President Robert Kaplan suggested the long-term equilibrium fed-funds rate could be as low as 2.25%.

It looks as if the Fed’s FOMC is nudging down the target for its fed funds rate, but ratcheting up the rate of change. Yet the Fed is still giving itself some wriggle-room not only to reduce the pace of rate hikes next year, but to duck a rise in December. All-in-all last night’s performance from Dr Yellen had something for everybody. Or as a tweet from @NorthmanTrader expressed it: “Yellen knows there's uncomfortable stuff in the data and she's doing a major CYA”.

So now we switch out attention to Dr Yellen’s colleagues to see if we can discover areas of consensus. This evening we have a speech from influential Federal Reserve Governor Lael Brainard entitled: "Labor Market Disparities and the Mission of the Federal Reserve.” This has the potential to be market-moving as has tomorrow’s speech from retiring Fed Vice-Chair Stanley Fischer. Hopefully we’ll get some much needed clarity, or at the very least some points of agreement between these three Fed members. If so, we could soon see if the current dollar rally is corrective, or the beginning of a trend reversal.

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Posted by David Morrison

Category: PM Bulletin


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