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Yellen signals rate path hinges on whether turmoil persists

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(Bloomberg) — Chair Janet Yellen said the Federal Reserve still expects to raise interest rates gradually while making it clear that continued market turmoil could throw the central bank off course from the multiple increases that policy makers have forecast for 2016.

“Financial conditions in the United States have recently become less supportive of growth,” Yellen said in testimony prepared for delivery Wednesday before the House Financial Services Committee in Washington. “These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market.”

Yellen, 69, kicked off two scheduled days of testimony on Capitol Hill by also telling lawmakers that uncertainty over China’s economic prospects and exchange-rate policy had “exacerbated concerns about the outlook for global growth” and contributed to the latest drops in oil and other commodities. A deeper commodities bust could trigger stresses around the world that threaten demand for U.S. exports, she said.

Yellen kept the door open for a rate increase in March, though she didn’t explicitly refer to any tightening timeline or the Fed’s next meeting.

“She is holding to her guns,” said Ward McCarthy, chief financial economist at Jefferies LLC in New York. “The financial market turmoil is not going to make them reverse course. It could have an effect on the pace at which they normalize rates, but they are still committed to normalizing rates.”

Eight weeks after raising interest rates for the first time in nearly a decade, Fed officials are struggling to judge whether financial market turmoil and a dimmer outlook abroad undermine their U.S. forecast and the need for additional policy tightening. They next gather to consider a rate change on March 15-16.

With her testimony on Wednesday, Yellen joined Vice Chairman Stanley Fischer and other senior Fed officials in declaring it’s too soon to tell whether sharp drops in stocks, oil prices and some bond yields represent passing volatility or reflect worsening global economic fundamentals that will dampen growth and inflation in the U.S.

Stephen Stanley, chief economist at Amherst Pierpont Securities LLC in New York, said Yellen’s remarks suggest the Fed is prepared to postpone, but not cancel, its plans for higher rates.

“The Fed is still taking the approach that this is a passing squall and it will clear, as it did last year,” he said, referring to a bout of market instability in August that caused the Fed to put off a rate hike in September before moving ahead in December.

Yields on two-year U.S. Treasury bonds were little changed following the testimony. Ten-year yields dropped about 0.04 percentage point to 1.72 percent.

Even as she detailed the risks to her outlook, Yellen indicated that the Federal Open Market Committee hadn’t changed its view that the U.S. economy will merit continued, though slow, tightening of monetary policy this year.

Gradual pace

“The FOMC anticipates that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” Yellen said, repeating language from the committee’s January statement almost verbatim.

Yellen noted that U.S. economic growth in 2015 slowed to an estimated 1.75 percent, restrained especially by the impact of a strengthened dollar on exporters. Still, she said, household spending had gotten a boost from lower fuel prices and steady jobs growth, a trend she expected will continue.  

“Ongoing employment gains and faster wage growth should support the growth of real incomes and therefore consumer spending, and global economic growth should pick up over time, supported by highly accommodative monetary policies abroad,” Yellen said.

The Fed chair repeated her projections that inflation will eventually move back toward the bank’s 2 percent target, downplaying concerns over declines in inflation expectations. She attributed the drop in market-based measures of inflation expectations to technical reasons, citing changes in risk and liquidity premiums in the market for U.S. Treasuries. Survey- based measures of expectations are low but “reasonably stable,” Yellen said.

World stocks, measured by the MSCI ACWI Index, have dropped about 10 percent since Dec. 31, and the S&P 500 has slipped about 9 percent. Oil has fallen beneath $30 a barrel compared to around $50 a barrel this time last year.

Safe haven

In another sign of strain, investors seeking a safe haven have piled into U.S. government bonds, driving yields lower. Treasury yields typically rise in anticipation of a higher federal funds rate.

Investor expectations for additional rate increases from the Fed this year have also collapsed. Based on pricing in fed funds futures contracts, investors don’t see the central bank hiking at all this year, compared to their expectation at the end of last year for two or three increases in 2016. Fed officials in December had forecast that four quarter-point moves would be warranted this year, according to the median of their estimates.

Yellen didn’t discuss the gap between the Fed’s December forecasts and current market expectations in her prepared testimony. The Fed’s monetary policy report, also released Wednesday, included the December projections.

Despite gloom in financial markets, data on the U.S. economy have included plenty of positive news, especially on the labor front.

While the pace of new job creation slowed in January to 151,000, labor market conditions were strong enough to lower unemployment to 4.9 percent, in line with the Fed’s estimate of full employment. The number of people who quit their jobs — a sign of confidence among workers that Yellen has highlighted in the past — also rose in December to its highest rate since April 2008.

Wages, perhaps reflecting the tighter labor market, have begun to creep up. That would be welcome at the Fed because inflation has languished below its 2 percent target for more than three years. The Fed’s preferred gauge of prices rose 0.6 percent in the 12 months through December, the fastest pace in a year.

The Fed chief is required to appear before Congress twice a year. The House panel, led by Texas Republican Jeb Hensarling, is slated to begin its hearing at 10 a.m., with Yellen fielding questions from lawmakers following delivery of her prepared remarks. She is set to appear Thursday before the Senate Banking Committee, led by Alabama Republican Richard Shelby.

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