Did Yellen intend to tighten policy last week?

When Janet Yellen was nominated to be Fed Chair in October 2013, the markets viewed her as the most dovish candidate the President could possibly have selected. Based on her decades of published economic research, that judgment seemed amply justified. At around the same time, the FOMC appeared to duck an obvious opportunity to taper its asset purchases in September. The Fed’s extreme dovishness appeared to be baked in.

However, in retrospect, last autumn turned out to be the high point for the dovish camp. Asset purchases were tapered in December; Ms Yellen quickly adopted language very close to the mid point of the FOMC, not the dovish end; and the statement after her first FOMC meeting last Wednesday led to an immediate jump of almost 15 basis points in the 5 year treasury yield.

Many commentators, including the normally well-informed Robin Harding and Jon Hilsenrath, argued that Ms Yellen had not intended to give such a hawkish signal. Viewed narrowly, that is probably right: Ms Yellen herself claimed there had been no change in policy last week.

But in a wider sense there has been an unmistakable shift in the FOMC’s centre of gravity in the past few months. The key to this shift is that the mainstream doves who have dominated policy decisions in the past few years have now essentially stopped arguing against either the tapering of the balance sheet or the start of rate hikes within about a year from now. Only the isolated Narayana Kocherlakota remains in the aggressive dovish corner.

The markets still seem entirely untroubled by this impending headwind for asset prices, but it is the new reality, unless the economy slows sharply.

Ms Yellen’s Debut

There was admittedly some fodder for those who want to view the Fed in a dovish light in last week’s pronouncements. The new forward guidance in the FOMC’s statement said that it will probably “maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends”.

It also said that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below the levels the Committee views as normal in the longer run”.

Ms Yellen said at the press conference that these parts of the statement should be seen as the Fed’s main guidance on its likely policy stance. “Lower for longer” has been replaced by “slower to a lower end point”. The main message of the FOMC was that economic “headwinds” (presumably household deleveraging and tighter credit standards) were still holding back GDP growth, so the “neutral” or equilibrium short rate is lower than in previous expansions.

This sounds dovish, so why did the bond and (briefly) the equity market sell off after the FOMC meeting? Undoubtedly, the main reason was Ms Yellen’s willingness to define what the FOMC meant by the “considerable time” between the end of tapering and the start of rate increases. She said this was “something on the order of six months”. Even if this was a rookie mistake (which is hard to believe), it still revealed very clearly what she was thinking, and it was a shorter period than most investors would otherwise have inferred from the word “considerable”.

The Fed’s Dots

The same message was contained in the Fed’s “dots”, which map the expected short rate path for all FOMC members (including non voters in future years). Ms Yellen said that these should not be seen as the primary means of communication about the Fed’s forecasts but, if that is the case, she should urge the committee to stop publishing them. At present, with forward guidance otherwise very fuzzy, they represent by far the most concrete form of forward communication offered by the FOMC. The markets are bound to examine them closely.

The dots clearly moved in a more hawkish direction last week, with the median dot rising by 50 basis points in December 2016. This reflects a distinctly tighter path for monetary policy than the median FOMC member indicated last December, and is also slightly more hawkish than the path built into the market’s forward curve on Friday:

Where Next?

Where does this leave the big picture for US monetary policy? The smoke signals are confused. Wage inflation remains too low, as Ms Yellen specifically pointed out. But it is surely significant that the hawkish shift in the dots is the first time this has happened since QE3 was launched in 2012.

Previously, the predicted date of initial rate increases has tended to be shifted further out almost every time the dots have been published. And this is where I believe we are learning something new about the attitude of the “mainstream doves” who have dominated Fed policy since 2008.

These mainstream doves have increasingly accepted that the falling unemployment rate may be telling the truth about labour market tightening, with less expectation that the participation rate will rebound. They have now abandoned the “Evans rule”, which previously envisaged a period in which inflation could rise to 2.5 per cent, and the Fed’s 2 per cent inflation target once again resembles a ceiling.

The optimal control approach to policy, under which rates would be deliberately kept lower than indicated by standard policy rules in order to ease policy at the zero lower bound, is no longer in favour. Instead, the path for rates is determined by the FOMC’s assessment of “headwinds”, which can rapidly change.

And there is increasing evidence that the FOMC as a whole, not just the hawks, is concerned about an excessive reach for yield in the financial system, as it certainly should be. (See the forensic Tim Duy on this.)

The upshot is that the committee has moved a long way from the highly unconventional territory it occupied a year ago. Paul Krugman complains that the liquidity trap has been replaced with a “timidity trap”. Timid or not, investors for the first time in years now face a two-way risk in US monetary policy.