The Fed's Game Changer?

Howard Schneider and Svea Herbst-Bayliss of Reuters report, Fed's Yellen says 'high-pressure' policy may be only way back from crisis:

The Federal Reserve may need to run a "high-pressure economy" to reverse damage from the 2008-2009 crisis that depressed output, sidelined workers, and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and aggressive steps may be needed to rebuild it.

Yellen, in a lunch address to a conference of policymakers and top academics in Boston, said the question was whether that damage can be undone "by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labor market."

"One can certainly identify plausible ways in which this might occur," she said.

Looking for policies that would lower unemployment further and boost consumption, even at the risk of higher inflation, could convince businesses to invest, improve confidence, and bring even more workers into the economy.

Yellen's comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether economic growth is close enough to normal to need steady interest rate increases, or whether it remains subpar and scarred, a theory pressed by Harvard economist and former U.S. Treasury Secretary, Lawrence Summers, among others.

Her remarks jarred the U.S. bond market on Friday afternoon, where they were interpreted as perhaps a willingness to allow inflation to run beyond the Fed's 2.0 percent target. Prices on longer dated U.S. Treasuries, which are most sensitive to inflation expectations, fell sharply and their yields shot higher.

The yields on both 30-year bonds and 10-year notes ended the day at their highest levels since early June, and their spread over shorter-dated 2-year note yields widened by the most in seven months.

Jeffrey Gundlach, chief executive of DoubleLine Capital, said he read Yellen as saying, "'You don't have to tighten policy just because inflation goes to over 2 percent.'

"Inflation can go to 3 percent, if the Fed thinks this is temporary," said Gundlach, who agreed Yellen was striking a chord similar to Summer's "secular stagnation" thesis. "Yellen is thinking independently and willing to act on what she thinks."

While investors by and large think the Fed is likely to raise interest rates in December this year, in a nod to the country's 5.0 percent unemployment rate and expectations that inflation will rise, they do not see the Fed moving aggressively thereafter.

"This is a clear rebuttal of the hawkish arguments," to raise rates soon, a line of argument pitched by some of the Fed's regional bank presidents, said Christopher Low, chief economist at FTN Financial.

Boston Federal Reserve Bank president Eric Rosengren, who is hosting the conference at which Yellen spoke, was one of three policymakers who dissented at the Fed's September policy meeting and argued for an immediate increase in interest rates. He feels a slight increase now will keep job growth on track and prevent a faster round of rate increases later.

But in a speech earlier on Friday Rosengren also referred to the economy as "nonconformist" because of its slow growth, and the general mood at the conference was that the sluggishness is largely the result of forces like aging and demographics that are unlikely to change.

"We may have to accept the reality of low growth," said John Fernald, a senior research at the San Franciso Fed. "Potential is really low."

That sort of assessment could figure importantly in coming debates over rate policy, and over whether support is building at the Fed to risk letting inflation move above its 2.0 percent target in order to employ more workers and perhaps encourage more investment. It could even impact the central bank's willingness to put more aggressive monetary policies back into play if the economy slows.

"If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand," Yellen said. It would "make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn."

From low inflation to the effect of low interest rates on spending, Yellen's remarks demonstrated how little in the economy has been acting as the Fed expected.

With public expectations about inflation so hard to budge, Yellen said tools like forward guidance, "may be needed again in the future, given the likelihood that the global economy may continue to experience historically low interest rates, thereby making it unlikely that reductions in short-term interest rates alone would be an adequate response to a future recession."

On Friday, I examined whether risks of global deflation are fading, noting the following:

You will recall I openly questioned Morgan Stanley's call that the greenback was set to tumble at the beginning of August (they blew that call).

I've always maintained that global macro traders should short currencies where deflation is prevalent (like Europe and Japan) and go long currencies where deflation has yet to strike (like the United States). I also warned my readers to keep an eye on the surging yen as it could trigger a crisis, especially another Asian financial crisis.

The way to think about currency moves is simple. A rising currency lowers import prices and exacerbates disinflation and/ or deflation. In a country like Japan which imports and exports a lot of goods, a rising currency will wreak havoc on its exports and attempts to reflate inflation expectations. And more deflation in Japan puts more pressure on other Asian economies to lower prices, exporting deflation to the rest of the world.

This is why it's a big deal if China can escape deflation. The thing you need to ask yourself is whether the pickup in inflation in China is sustainable and credible or doomed to dissipate quickly depending on what is going on in Japan and the Eurozone. Because if Japan and the Eurozone can't escape deflation, it's hard to envision China escaping deflation (there is a reason why China's exports were down sharply, and it has to do with weak demand from Europe and elsewhere).

And if the US dollar keeps rising, and global deflation comes back with a vengeance, it's going to be hard for the US to escape deflation too.

One thing I can guarantee you, if the US dollar keeps rising, the Fed will proceed very gradually in terms of rate hikes. It might hike rates 25 basis points in December (not convinced it will) and wait to see the effects on emerging markets and China.

A rising US dollar will also effectively cap commodity prices (lower oil, gold, energy prices) and even long bond yields (lower import prices mean lower inflation expectations going forward). It will also alleviate pressure on the Fed to raise rates as a rising dollar tightens financial conditions.

My thinking is that the pickup in PPI inflation in China might allow the Fed to proceed with one more rate hike in December but I am far from convinced it will hike rates this year. In fact, I'm on record stating the Fed should not raise rates now.

And after reading Fed Chair Janet Yellen's speech on The Elusive Great Recovery, I interpret it the same way Jeffrey Gundlach does, the Fed is willing to stay accommodative for longer:

Federal Reserve Chair Janet Yellen's speech on Friday on running a "high pressure" economy with a tight labor market to reverse some of the negative effects of the Great Recession of 2008 suggests the U.S. central bank will stay accommodative for longer, said Jeffrey Gundlach, chief executive of DoubleLine Capital.

"I didn't hear, 'We are going to tighten in December,'" Gundlach said in a telephone interview. "I think she is concerned about the trend of economic growth. GDP is not doing what they want."

Gundlach said the GDP Now indicator from the Atlanta Federal Reserve has been cut in half to only 1.9 percent for the third quarter after only 1.1 percent actual for the first half of this year. "GDP Now keeps fading away. If we get only 1.9 percent GDP for third — and fourth quarters — we are looking at only 1.5 percent GDP this year," he said.

Gundlach, who oversees more than $106 billion at Los Angeles-based DoubleLine, said Yellen's remarks suggest that she embraces the hypothesis introduced by former U.S. Treasury Secretary Larry Summers, who said that secular stagnation, or a lack of demand, is pushing down global growth.

"I think Yellen is saying, "You don't have to tighten policy just because inflation goes to over 2 percent. Inflation can go to 3 percent, if the Fed thinks this is temporary," Gundlach said. "Yellen is thinking independently and willing to act on what she thinks."

Has Janet Yellen lost her marbles? Isn't she worried about cracks in the bond market and the bursting of the so-called bond bubble?

I believe Friday's speech was a game changer at the Fed because it's openly admitting what I've long been warning of, namely, the deflation tsunami is coming, the bond market is worried, and there is a sea change at the Fed to try to stave off the rising risks of global deflation.

I've long maintained the Fed would be nuts to raise rates in a world where global deflation is the clear and present danger. All this will do is reinforce deflationary headwinds around the world and risk another emerging markets crisis and a prolonged deflationary episode, one that might hit the US economy.

I also warned no matter what the Fed and other central banks do, all they're doing is buying time. Inevitably, the deflation tsunami will strike the developed and emerging world, and this will likely bring about a massive fiscal policy response, but by then, it will be way too late.

Of course, there is a risk of staying accommodative for longer, namely, that all it will do is exacerbate rising inequality and the ongoing retirement crisis, which are two structural factors I keep harping on when I discuss the lack of aggregate demand in the United States and elsewhere.

Importantly, while staying accommodative for longer buys the Fed time, if it doesn't succeed in overshooting its inflation target, then get ready because ZIRP and NIRP will be with us for the next decade(s). 

On that last point, I want you to read a recent comment by Brian Romanchuk of the Bond Economics blog where he examines whether Treasury yields will escape their low yield trap. Brian also has his doubts on fiscal policy and rightly notes while a cyclical bond bear market can happen, wiping out risk parity funds and big obscure hedge funds loading up on Treasuries, a structural bond bear market is highly unlikely until policymakers address structural factors behind persistently weak growth (like rising inequality and lack of aggregate demand).

Below, the Boston Fed’s 60th Economic Conference, “The Elusive 'Great' Recovery: Causes and Implications for Future Business Cycle Dynamics” Bank President Eric Rosengren offered opening remarks and Federal Reserve Chair Janet Yellen delivered the keynote address.

Later on Monday, Fed Vice Chairman Stanley Fischer will deliver a speech which I will embed if it becomes available.

But in my opinion, the key speech was delivered by the Fed Chair on Friday and it's a game changer because it signals the Fed is losing its fight on deflation and it needs to remain accommodative for longer and investors might need to brace for a violent shift in markets.

Update: In a speech at the Economic Club of New York, Why Are Interest Rates So Low?, Federal Reserve Vice Chairman Stanley Fischer suggested that low rates can lead to longer and deeper recessions, making the economy more vulnerable. He added they can also threaten financial stability, although the evidence so far doesn't show a heightened threat of instability.

I would focus more on Fed Chair Yellen's speech than the one given by Stanley Fischer. Fischer has been warning of the dangers of low rates for a long time and he hasn't convinced his colleagues on the Fed to reverse course. I believe the reason is that the doves, led by Yellen, call the shots and they feel the environment is not right to hike rates.