The Fed’s Fascinating Footnotes

We like footnotes.^[i] And it seems Fed head Janet Yellen does too, after adding a slew of pretty darn interesting ones to her speech last week at the University of Massachusetts. Most observers seemed more interested in pondering whether Ms. Yellen is wilting under the pressure of a rate hike.^[ii] Others buzzed about both her health and a potential rate hike, especially after Yellen indicated the latter was still appropriate for "later this year" in a speech last Thursday. But while most pundits were focused on Yellen's latest "forward guidance," we found some of her overlooked comments more interesting-and insightful-for investors.

In a speech of more than 5,500 words, folks zeroed in on a couple lines-misplacing their focus, in our view. Here are the words headlines have highlighted (bold emphasis ours):

This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year ...

And in the conclusion:

Most FOMC [Federal Open Market Committee, the 10-member panel that enacts policy decisions] participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds later this year, followed by a gradual pace of tightening thereafter.

However, all this attention on timing isn't useful for investors. The Fed's attempts at "transparency" and forward guidance have only added uncertainty, not clarity, about future actions, and Yellen's comments don't necessarily mean a rate hike for sure happens. Consider December 2012, when the Fed said it would use a 6.5% unemployment rate as a threshold for considering an initial Fed funds rate hike-linking expectations to economic data. However, the unemployment rate fell much faster than the Fed anticipated. The FOMC projected 6.5% unemployment at the end of 2015,^[iii] but by March 2014 the rate was already 6.7%^[iv]-and the Fed ditched the threshold. (The unemployment rate fell to 6.2% two months later.) While we don't begrudge the Fed for getting a long-term economic projection wrong, it exemplifies how central bankers' words don't automatically translate into action.

Yellen's latest salvo-that an initial rate hike will likely happen "later this year"-could prove even more problematic. By anchoring themselves to "later this year," the Fed has unnecessarily given the impression there is a three-month window to hike rates. If the FOMC votes to not raise rates by yearend-for any reason, data-related or not-it potentially compromises their credibility. The Fed has called US economic conditions "favorable" for a while now, and the longer they wait, the more folks question the veracity of their words. They may doubt the Fed's forecasting acumen or wonder what the Fed "really thinks" is afoot.

However, Yellen's speech was also filled with lots of interesting points, revealing her perspective on several widely discussed central bank issues. She just didn't say them, because they were in the footnotes.^[v] As The Washington Post's Ylan Mui highlighted , Yellen opined on topics ranging from unemployment targets to the impact of the Fed's "extraordinary" monetary policy measures. Now, overall, we found Yellen's analysis a bit mixed. For example, we don't agree with her interpretation that the double-digit inflation of the 1970s was caused by the "wage-price spiral," in which prices follow wages higher, a function of labor market "tightness." Rather, President Nixon's price controls and the misallocations they caused were the primary culprit. Instead of wage connections, we subscribe to Milton Friedman's inflation argument: It is always and everywhere a monetary phenomenon, and the quantity of money coursing through the economy matters much more. We also have qualms with the notion the Fed's "easy" money policies starting in 2008 are only starting to play out now. While monetary policy impacts the economy at a lag, a seven-year delay is a bit of a stretch. Evidence suggests that later iterations of the Fed's quantitative easing (QE) program flattened the yield curve-hurting, not helping, economic growth by discouraging lending.

Other insights, however, were more sensible. Yellen's opining that a hard unemployment rate target isn't necessary or workable is spot-on. As she notes, many "nonmonetary factors" impact the labor market, so the Fed shouldn't (and can't) pursue an ideal unemployment rate. Yellen also tackles the popular econowonk suggestion that raising the Fed's inflation target from the current 2% y/y headline PCE rate to, say, 4% would cause the public to expect a faster pace of rising prices in the future. This, some suggest, would trigger them to spend more today, spurring economic growth. The Fed chair is sensibly skeptical of monetary policy that "relies primarily on the central bank's theoretical ability to influence the public's inflation expectations directly by simply announcing that it will pursue a different inflation goal in the future." Said another way, pursuing a 4% inflation target presumes slower growth because the general public has priced in the Fed's targeted 2% annual inflation rate. Yet we see little evidence folks know who Janet Yellen is, let alone that the Fed is aiming for 2% inflation. Changing that to 4% isn't going to do much, in our view. Additionally, as Yellen notes specifically on inflation targeting, "... changing the FOMC's long-run inflation objective would risk calling into question the FOMC's commitment to stabilizing inflation at any level because it might lead people to suspect that the target could be changed opportunistically in the future." In other words, it is a credibility issue. If the Fed randomly decides to alter its stance on an established objective, what would stop it from changing its rules at its whim? Greater uncertainty tends to make things worse, not better.

More broadly, Yellen argues monkeying around with the Federal Reserve's mandate likely won't have the effect proponents of change believe. Many factors are simply out of a central bank's control, and assuming monetary policy alone is the answer is a fallacy (see Japan for more). Central banks aren't all-powerful entities that can pull a few levers to boost growth at their fancy. Plus, central bankers are people, and people aren't perfect. They carry their own personal biases and interpretations of ideal policy, but that doesn't make it correct. The Fed is widely considered to be responsible for greatly extending and deepening the Great Depression and triggering bank runs in the period 1930-1932. The massive reserve requirement increase in 1937 caused the return to recession. In 2008, one need only look at the transcripts to see how well wide of the mark Fed policymakers' choices were.

While monetary policy is an important market driver to consider, we caution investors from reading into all the noise surrounding it. Predictions about when the Fed will hike aren't helpful or meaningful today. And as we've said often, central bankers' words matter less than their actions. However, those words-uttered aloud or not-can also indicate their viewpoints and perspective on certain matters, providing valuable insight on what may (or may not) impact their decisions, and helping put pundits' proclamations in perspective.