Developments in the Greek crisis justifiably diverted attention from Federal Reserve Chair Janet Yellen’s semi-annual testimony to Congress last week.
Most of the coverage tended to focus on Yellen’s valiant efforts to parry attacks on the autonomy and accountability of the central bank (past, present and future). Yet the Fed chief also provided important insights about the future of interest rate policy:
Timing: Based on what she knows today, Yellen is inclined to initiate the Fed’s hiking cycle this year, and perhaps as early as September. Instead of waiting until 2016, when she might have to raise interest rates more aggressively, she would rather lead a gentle campaign of increases that starts this year and proceeds gradually, as new economic data warrants.
Rationale: Although wage growth remains too muted, Yellen anticipates the labor market will strengthen further, carried by robust job creation. Combined with moderate growth in domestic demand, the brighter employment picture is expected to underpin the continued rebound from disappointing first-quarter growth.
Not just cyclical: Yellen seems to be warming to the notion that the U.S. economy faces more than cyclical headwinds. By taking into account the role of structural issues, including moderate productivity growth and sluggish supply responsiveness, she can be less worried about inflation persistently undershooting the Fed’s objective.
International context: Although the Greek crisis is of concern, Yellen doesn’t believe that its effects are limited to the downside. She also sees upside risk for Europe.
Format: The Fed chief provided further indications that this would not be a traditional cycle. Instead, it is likely to involve a new kind of stop-go pattern. Previous Fed chairs have preferred to set hikes at each meeting until their desired rate destination is reached. Yellen will adopt a more conditional approach.
Terminal point: Yellen also is warming to the idea that the increases could end with a policy interest rate that is well below historical averages, but she has offered no further details.
Global divergence: While concerns about the strength of the dollar could re-emerge, they weren’t described as an impediment to initiating the interest rate hiking cycle this year. At this stage, Yellen isn’t overly worried that the Fed, with a policy of reduced monetary accommodation, will diverge even further from other central banks (particularly the European Central Bank).
Even though she provided these guideposts on her thinking, it also was obvious that Yellen wishes to retain significant policy flexibility. This was clear in her reluctance to attempt to manage market expectations more aggressively. Over the last few months, some investors have erred in anticipating that the rate hikes would begin in 2016. They would pay more attention to Yellen’s seven points and change their expectations if, as is likely, the U.S. economy continues to heal, and if the latest Eurogroup deal rapidly restores some sense of normality to the imploding Greek economy (which is possible, but much less likely).
