Christian Hawkesby says incoming Fed chairman Janet Yellen has the best economic forecasting record since the GFC among voting FOMC members

Christian Hawkesby says incoming Fed chairman Janet Yellen has the best economic forecasting record since the GFC among voting FOMC members

By Christian Hawkesby

As President Barack Obama’s nominee to become the next Chair of the US Federal Reserve, Janet Yellen is set to become one of the most powerful people in global markets in 2014.

Traditionally, overnight interest rates set by the US Federal Reserve have been a key driver of global fixed interest markets, including New Zealand’s long-term interest rates.

But since the global financial crisis (GFC), US monetary policy has taken on even greater importance. With overnight interest rates set near zero and US money supply expanding through Quantitative Easing (QE), the actions of the US Federal Reserve have underpinned fixed interest, foreign exchange, commodity, credit and equity markets.

One of the key judgements through 2014 will be whether the US economic recovery is sufficiently strong to enable a gradual withdrawal or ‘tapering’ of some of this extraordinary amount of stimulus.

There is no question that Janet Yellen is qualified for such a massive task. She has been the Vice Chair of the Federal Reserve since 2010. Previously she was CEO and President of the Federal Reserve Bank of San Francisco, the Chair of the White House Council of Economic Advisors under Clinton, and a Professor at University of California in Berkeley.

Over the past three years, alongside Ben Bernanke and Bill Dudley (New York Federal Reserve President), Yellen has been at the heart of Federal Reserve policymaking.

A key part of Yellen’s role has been formulating the Federal Reserve’s communication strategy, which has included its unprecedented ‘forward guidance’, pre-committing to keep interest rates near zero until 2015. In December 2012, this later evolved into their policy for specifying the exact economic conditions needed to see it maintain its loose policy stance: the unemployment rate above 6.5% and projected inflation below 2.5%.

However, Yellen is perhaps most closely associated with the so-called ‘optimal control’ framework for monetary policy. The key idea underpinning this framework is that the costs of the US Federal Reserve missing its economic targets are not linear. In other words, unemployment being 2% above its target is more than twice as bad for the economy as being 1% above its target. In the aftermath of the GFC, the implication has been for the US Federal Reserve to do whatever it takes (to borrow a phrase from the European Central Bank) to support the US economic recovery. Hence the Fed’s continuing attempts to add more stimulus through QE1, QE2, and QE3.

In her confirmation hearing with the Senate Banking Committee, Yellen reiterated her commitment to these ideas by saying that “I consider it imperative that we do what we can to promote a very strong recovery,” and “It’s important not to remove support, especially when the recovery is fragile and the tools available to monetary policy, should the economy falter, are limited given that short-term interest rates are at zero.”

There are also some hints to Yellen’s policy views in a recent research paper published by the US Federal Reserve, which is seen as a more complete formulation of Yellen’s ‘optimal control’ framework. The results of the paper have been interpreted by a number of commentators as an argument for the Fed to lower its unemployment threshold to 5.5%, implying that US overnight interest rates would stay near zero for even longer than currently signalled.

Given this background, it is easy to see why Yellen has been described as an inflation dove. US bond yields fell when her nomination was announced.

However, central bankers never like to be labelled hawks or doves. The reality is that Yellen’s policy stance has been driven by her view of the US economy. Of all the voting members of the Federal Open Market Committee (the interest rate setting committee), Yellen has had the best economic forecasting record since the GFC, correctly picking the need for exceptional policy support. In years to come, as the outlook for the US economy evolves, Yellen’s views will also evolve.

At Harbour Asset Management, we believe that underlying US economic momentum is picking up, and, if it continues, that should eventually push global interest rates higher in the medium term. However, in the meantime, Yellen clearly has a very high threshold for the evidence she would need to see to change her view of the US economy. Consequently, we are expecting ongoing easy monetary policy to cause global bond yields to remain relatively low for some time yet.

*Christian Hawkesby is director of fixed interest at Harbour Asset Management.

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6 Comments

An interesting piece, the appointment speaks volumes for low for a long time, backed up by,
In terms of the US picking up, the financial condition of a number of the US's states seems perilious.  eg their pension funds bankrupt/unfunded, incomes decimated, borrowed to the hilt. Cities, I wonder how many are close to following Detroit. The states in the US seem to be following the last line available, put up taxes to cope, way late. Petrol/oil still way expensive.  
Japan seems to still be stuck in the mud.
EU looks to be going into recession with already high un-employment and especially youth. 
China....messy.
So is medium term 5 years away?  10 years?  We have been in this 5 years now and every so often we get these upbeat "readings" that never materialise....
regards

I find it informing that financial ppl/sector seems to think there is a recovery, almost without contention every month....for 4 or 5 years.
Maybe  pieces with short and medium term views from other sectors?
We've seen farmers.
Real estate well, yes.
What about by John Walley(?) or similar (assoc of manufacturers?) might be enlightening.
 A similar piece from retailers assoc?
Maybe then have them back every quarter to review how their expectations went and wat they see in the future.
regards

Excess reserves at the Fed is over $2 trillion dollars...   If Banks ever decide to invest even some of that money in the mkts... just imagine....
-ve real interest rates for longer ....   might well motivate the Banks to chase higher returns..???
By 2015 ...if the Fed keeps up its buying of  bonds....   its Balance sheet will be approaching $5 trillion .....  
This is really extraordinary stuff...   an ocean of liquidity.
I'm not smart enough to figure out how this might unfold.... but I do think Janet Yellan has very few choices....
If the US economy eventually picks up, maybe the mkts will react negatively..??

Is anyone paying attention?
 
Yes indeed:
 
Simon Potter, the Federal Reserve Bank of New York’s markets group chief, said the Fed’s new reverse repurchase agreement tool probably will be a key part of how the central bank eventually tightens monetary policy.
 
Market “participants have indicated that they expect that a facility, if executed in full scale in the future, should be an effective tool for increasing the Federal Reserve’s control of short-term money market rates,” Potter said yesterday in a speech in New York. He is in charge of the System Open Market Account used in implementing monetary policy.
 
Fed officials have been testing the new tool -- known as a fixed-rate, full allotment overnight reverse repo facility -- aimed at improving their control of near-term borrowing costs when they tighten policy by siphoning off excess cash in the banking system  Read more
 
Fed open market operations can be viewed here.
 
But there are increasing risks associated with weaning large financial institutions off  Repurchase Agreement (RP) dependent maturity transformation trades Read more 
 
Stress is mounting:
 
Volatility in Treasuries as measured by Bank of America’s Merrill Lynch MOVE Index (BUSY) climbed to 73.15 yesterday, the highest level since Oct. 16. That compares with a six-month low of 58.31 on Nov. 18.
 
The “break higher” above the index’s 73 level confirms a turn in trend, MacNeil Curry, head of foreign-exchange and interest-rates technical strategy in New York at Bank of America Corp., wrote in a note to clients. Volatility may climb between 81 and 87, the highest since Oct. 1, and potentially higher as 10-year yields increase to the 3 percent level reached in September and beyond, he wrote. Read more  and  more

That's an interesting read re the Fed's stat release. One wonders why the Fed still pays interest beyond the upper requirement limit? Two thirds of the QE programme has returned through the back door. Then add fiscal consolidation. Must be frustrating!