Markets had a predictable immediate reaction to comments by Federal Reserve Chair Janet Yellen on Tuesday that they interpreted as relatively dovish signals about the thinking of the world’s most important central bank.
Within minutes of her remarks, risk assets rose, government bond yields fell, the dollar weakened and the VIX declined. Sustaining this trend will require two policy signals, one short-term and one longer-term — assuming that the global economic environment remains relatively stable.
She used her much-anticipated lunchtime speech to the Economic Club of New York to paint a cautious and measured picture of the U.S. economy, and of the delicate balance that Fed policy makers must maintain.
The Fed chair acknowledged that the overall mixed U.S. picture for 2016 so far contained encouraging signs, including the continued strengthening of the labor market. Yet she also emphasized “external” risks, including slowing global economic conditions, the level of the dollar and market reactions to China’s currency policy. She even recognized the influence of some structural headwinds to growth and the unusual uncertainty facing the inflationary outlook.
This cautious assessment of the economy was accompanied by a rather measured appraisal of what the Federal Reserve can do to further support growth as part of its dual mandate of maximum employment and stable inflation.
She argued that the Fed had not run out of policy ammunition and stressed the need for careful policy gradualism within a cautious approach overall — music to the ears of markets that have been conditioned to depend on the Fed to suppress financial volatility and push asset prices higher. But she also cautioned about the extent to which the central bank can continue to be effective. And she refrained from venturing into the debate about negative interest rates, which has been fueled by the decision of her counterparts in Europe and Japan to push theirs below zero.
Judging from the immediate reaction, the markets liked her overall message, which they interpreted as an indication of continued support from the Fed. Consequently, stocks and corporate bond prices rose within an overall rally for risk assets. Government bond yields fell as traders revised down their expectations of the path of future policy interest rates. The dollar depreciated as the VIX, commonly referred to as a measure of market fear, fell.
Sustaining this movement in the short-term will require Yellen’s message to be supported by her Fed colleagues in the next few days. This is far from certain.
The mixed economic signals, along with concerns about the collateral damage to markets and the economy caused by the continued excessive reliance on exceptional Fed policies, have led some U.S. central bank officials to give a more cautious message in the last week. Some even appeared to suggest that a rate hike in April was a real possibility.
Over the longer term, the challenge takes on an added dimension. Even if the Fed is willing to continue to its exceptional support to markets as a way to stimulate the economy, the effectiveness of this approach is far from assured. And this does not relate only to the declining benefits of a policy that has been in place for much longer than anyone envisaged. There also are rising concerns about the unintended consequences of the Fed’s “only-game-in-town” status, including what it implies for future financial stability.
Finally, and perhaps most importantly for the well-being of both the U.S. and global economies, the biggest takeaway from Yellen’s important speech could go beyond the specific issues she covered. Her remarks and their context could be taken to suggest that, for reasons beyond its control, the Fed is increasingly held hostage by three forces that could threaten its own credibility and political autonomy:
Politicians who repeatedly fail to take advantage of the time the Fed buys for them, withholding a much-needed comprehensive policy response to the cyclical and structural challenges to the U.S. economy, as well as limiting America’s ability to have a leadership role in global policy coordination.
An international economy that is losing its growth traction, however sluggish, as structural and cyclical headwinds converge and as the political context becomes more complicated both in Europe and in some parts of the emerging world..
Financial markets that feel empowered and enabled to force the Fed’s hand — regardless of the underlying economic and corporate fundamentals.