Yellen is confused & confuses

She made two apparently contradictory statements on Friday (Sept 14).

In one:

Former Federal Reserve Chairwoman Janet Yellen said Friday that she is concerned the economy might overheat.

“At a time like this, I would be worried that the economy is in a situation where it could overheat,” Yellen told reporters on the sidelines of a conference at The Brookings Institution.

“I don’t think it would be very rapid but I think it could occur,” she said.

Yellen said her view is based on the empirical relationship between inflation and unemployment — known as the Phillips curve, a closely watched relationship by many at the Fed. She said she thinks the unemployment rate is “below full employment,” meaning it is putting upward pressure on prices.

In another:

The U.S. Federal Reserve should commit to letting economic booms run on enough to fully offset collapses like the 2007 to 2009 Great Recession, former Fed chair Janet Yellen said on Friday, urging the central bank to make “lower-for-longer” its official motto for interest rates following serious downturns.

“By keeping interest rates unusually low after the zero lower bound no longer binds, the lower-for-longer approach promises, in effect, to allow the economy to boom,” Yellen said in remarks delivered at a Brookings Institution conference.

… The approach reflects much of current Fed policy, which was largely set before Yellen left office. Officials, for example, view their 2 percent inflation target “symmetrically,” and say they are willing to tolerate inflation a bit higher than that without overreacting, just as they were willing to tolerate inflation a bit weaker.

But Yellen is urging them to go a step beyond, adopting some metric — whether a measure of lost output, the sum of below target inflation, or some other measure — that it would hit before raising rates too high, if at all.

Maybe in the first remark, she´s thinking about the present economy, while in the second she´s looking ahead to the next downturn (assuming it will be “serious”?)

Yellen took the Fed helm in February 2014. Two months later, in the April FOMC Meeting, she inaugurated the “monetary normalization” discussion. The importance of this discussion can be gauged by how it affected members’ expectations of the policy rate going forward.

In the March Meeting (before the “normalization” discussion began), of the 16 “votes” for the FF rate in 2015, 11 thought it would end 2015 at, or below 1%, while 5 put it in the 1.25%-3% range.

In the June Meeting, the first after the start of the “normalization” discussion, the number of those expecting the FF rate to be in the 0.25%-1% range fell from 11 to 8, while the number of those expecting the FF rate at the end of 2015 to be in the 1.25%-3% range increased from 5 to 8.

In the September Meeting, the “hawks” became the majority, with 10 of the 16 anticipating the FF rate to be in the 1.25%-3% range by the end of 2015.

We know nothing of the sort happened, with the FF rate increased only once, by 0.25 bp on December 15, 2015.

Monetary policy, however, tightened. How do we know, if the policy rate barely moved? Obviously, Fed rate expectations are important and will affect economic outcomes. By the “tightening bias” introduced with the start of “normalization” discussions, the economy experienced the “Yellen Slump” between early 2015 and mid-2016. The chart illustrates.

It´s fair to say Yellen was thinking more about “overheating” than letting the economy run “hot” for a while, as she argued after the slump.

Just two weeks before “Hike Day”, Andrew Levin, a former Fed staffer wrote a cautionary note (in the spirit of Yellen´s “let it run” argument)

The Federal Reserve has signaled that it will begin raising short-term interest rates at its Dec. 15 meeting. The Federal Open Market Committee has maintained its federal funds rate target close to zero for seven years, and it has frequently described the removal of monetary policy accommodation as “normalization.” So many will infer from this decision that the Fed judges the economy to be sufficiently close to “normal” to warrant the onset of tightening.

Yet current economic conditions are not consistent with this action, and starting the tightening process now would pose substantial risks to the Federal Reserve’s statutory goals of maximum employment and price stability.

The Fed, however, would have none of that, appearing dead set in “normalizing”. Just three weeks after “H-Day”, Vice-Chair Stanley Fisher said:

Federal Reserve Vice Chairman Stanley Fischer said policy makers’ forecasts predicting four interest-rate increases in 2016 were “in the ballpark.”

They were again wrong about the hiking pace. Seven months later, in August 2016, Fisher said:

Federal Reserve Chairwoman Janet Yellen’s speech to the Jackson Hole summer retreat was “consistent” with a possible two rate hikes this year, her top deputy said Friday.

In the end, there was only one hike in December 2016, bringing the FF rate to 0.75%.

A recent speech by Lael Brainard indicates the Fed is again prone to tightening:

In thinking about how we should set the federal funds rate, many policymakers and economists find the concept of the neutral rate of interest to be a useful frame of reference. So, what does the neutral rate mean? Intuitively, I think of the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.

Focusing first on the “shorter-run” neutral rate, this does not stay fixed, but rather fluctuates along with important changes in economic conditions.

In many circumstances, monetary policy can help keep the economy on its sustainable path at full employment by adjusting the policy rate to reflect movements in the shorter-run neutral rate. In this context, the appropriate reference for assessing the stance of monetary policy is the gap between the policy rate and the nominal shorter-run neutral rate.

So far, I have been focusing on the shorter-run neutral rate of interest that is responsive to headwinds or tailwinds to demand. The longer-run equilibrium rate is a related concept. The underlying concept of the “longer run” generally refers to the output growing at its longer-run trend, after transitory forces reflecting headwinds or tailwinds have played out, in an environment of full employment and inflation running at the FOMC objective.

The Path of Policy

What are the implications for policy? Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective. With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate. Further out, the policy path will depend on how the economy evolves.

These developments raise the prospect that, at some point, the Committee’s setting of the federal funds rate will exceed current estimates of the longer-run federal funds rate. Indeed, the median projection in the SEP has this property. This raises the possibility of a flattening or inversion of the yield curve in the event that term premiums do not rise from their currently very low levels.

She is not unduly worried about yield curve inversion

Like many of you, I am attentive to the historical observation that inversions of the yield curve between the 3-month and 10-year Treasury rates have had a relatively reliable track record of preceding recessions in the United States. But unlike these historical episodes, today the current 10-year yield is very low at around 3 percent, which is well below the average of 6-1/4 percent during the decades before the crisis.

In which case, another “slump” may be in the pipeline!

PS On Yellen´s suggestion of “adopting some metric”. The metric “the sum of below-target inflation” smells a lot like adopting a temporary price level target, as suggested by Bernanke. As we argue, a much better “metric” (not temporary, but permanent) would be a Nominal GDP Level Target.

Adopting a “measure of lost output” metric will get us nowhere, simply because that metric (just as the natural rate of interest) is always changing, in fact, converging to “zero”. As that chart indicates, at present there is no “lost output”, with the actual output being somewhat above “potential”, and consistent with unemployment (u) being at present below u* (the “natural” rate of unemployment).


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