Yellen’s speech Friday could best be summarized as “we don’t know jack.” There were NINETEEN question marks in a 3,170 word speech. The theme of the conference was not “Questions to Answer Post The Great Recession,” or some related theme that requires the asking of so many questions. It was “The Elusive ‘Great’ Recovery: Causes and Implications for Future Business Cycle Dynamics.” It would have been perfectly acceptable for her to have the answers (or at least pretend) and lay out a path to recovery. Instead what we got was a string of confessions about how little we know and “maybe it could be this or maybe it could be that.”
Do you know what happens when someone is unsure of something (or in this case, a bunch of things)? Nothing. You can’t do anything (aggressive) when you are not sure what is going on. Some may call this “analysis paralysis,” but I think it’s more like “paralysis by uncertainty.”
The FOMC has no “grand plan.” How can you when you have no idea about so many things – supply, demand, inflation, financial linkages, international linkages and potentially misleading aggregated statistics. Questions in all of these areas were raised. To me, this means monetary policy will go on as a meeting-by-meeting proposition. The Fed likes to call it “data dependent.”
I have no problem with current “risk management framework” to monetary policy (aka the “hike when it feels right” approach). But in my opinion, this could lead to earlier hikes than the market thinks – especially while the current rate is below the “neutral” rate. This is because a number of FOMC members lean hawkish, and they will keep asking for hikes until the actual rate gets close enough to their model rate (assuming the economy goes close enough to a “2% GDP” pace). We all know their model rates lean “too high.” So all other things being equal (and all other things may not be equal because of things like Article 50), you should expect earlier than later hikes. I’m not saying the Fed is going to go nuts with hiking – they will be gradual. I’m just saying the current “two hikes a year” dot plot pace should not be so easily dismissed (as the markets have done).
Apparently the markets thought Yellen said something new when she mentioned “hysteresis.” She wondered if running a “high-pressure economy” may be able to reverse adverse supply-side effects. Let’s put aside the fact that the “high-pressure economy” was just a hypothetical musing she threw out there (because she doesn’t know). That’s some revolutionary and shocking stuff, that caused the curve to dramatically steepen. It’s not like this wasn’t already priced into the curve (via lower rate hikes in the next few years) and these implications are nothing at all like those for the “optimal control” models (lower rates for longer) that she has been talking about for the past four years. (Sarcasm intended) Holy making-something-out-of-nothing, Batman!
The most interesting part of her speech was the part on heterogeneity. We have two groups of people on opposite sides of the age spectrum that could shed a lot of light on what is going on in the economy. The retiring baby boomers have been a huge factor in many areas, including productivity, labor force participation, value of assets, wage inflation, part time workers, etc. But the younger people in the work force should also be studied. As a cohort, they seem much different than the previous generations. Whether it’s labor participation, home ownership, spending habits, etc. Aggregating statistical data across the different groups will cause the economic picture to be muddled. Looking at the individual groups will provide better information with which to act.
Lastly, on a side note, I strongly suspect some market participant(s) has access to the Fed releases/speeches in advance. I’ve wondered this for a while – especially after a few too-prescient think tank reports. But you generally need some interesting curve move to corroborate this. We got one and a half this week. The curve steepened some before Yellen’s speech on Friday, and we got a continuation afterwards. The markets rallied before the FOMC minutes on Wednesday and rallied afterwards on the bullish minutes. Now, part of this could be that there are some “smart” people working at think tanks or other research desks that can anticipate what will be said. This could be a plausible explanation. But considering there has been past history of a Fed leak, and considering there is great mobility between the Fed and Wall Street (and equivalent), to claim that there are no inappropriate exchanges seems too idealistic. Nobody thinks insider trading does not happen – there are insider trading cases going on all the time. This is no different.
From a game theory perspective, this implies that if we see a notable curve move prior to a Fed event (say the release of the minutes or a Fed speech), we could think about going the same way. This may not apply to the FOMC statement, since that is presumably written the day of. I have no evidence. So let’s test this hypothesis as the year goes on.