Markets have been pretty pleased with the Federal Reserve of late, but don't expect that to last.
In a speech to the Economic Club of New York on Tuesday, Fed Chair Janet Yellen argued that recent turmoil in the global economy has "not materially altered the Committee's . . . most likely outlook for economic activity and inflation" over the next couple of years.
Yellen's remarks could undercut what the market had taken as comforting news lately—the fact that the majority of voting members of the Federal Open Market Committee now see interest rates settling at 0.75% or below by the end of 2016, about 0.25% less than just a few months ago.
Two weeks ago, Yellen's view, along with nearly all the members of the Federal Reserves voting committee, appeared finally to be in harmony with the market's view of where interest rates will be by the end of the year, making it less likely that the central bank will enact more than two rate hikes this year. That calmed the market, which has been up roughly 3% over the pase month.
Yellen's speech today, though, suggest there is less agreement between the Fed and markets than it appears.
The single most important metric the Fed studies is inflation, and markets and the Fed see this metric as going in different directions. The Fed sees inflation reaching its goal of 2% annually before the end of next year, while the market is implying at 10-year inflation expectation of 1.65%, meaning that the public currently expects the inflation rate to be less than 2% on average over the next decade.
If inflation fails to rise above the Fed's 2% target over the next decade, the central bank is going to have a hard time justifying raising rates much at all over that time period, regardless of how low the unemployment rate falls. The Fed's models, however, can't conceive of a world where the unemployment rate continues to drop as it has in recent months without putting upward pressure on inflation.
So Federal Reserve officials have been at pains to convince markets that they are wrong about where inflation and where the global economy is headed. Earlier this month at a speech to the National Association for Business Economics, Fed Vice Chairman Stanley Fischer argued a link remains between falling unemployment and higher inflation and that, "we may well at present be seeing the first stirrings of an increase in the inflation rate."
Other Fed officials, like San Francisco Fed President John Williams and Atlanta Fed President Dennis Lockhart have advocated for raising rates as soon as next month, though they are currently not part of the FOMC and therefore don't get a vote. In a speech Tuesday in Singapore, Williams argued that given all of the headwinds forcing inflation down, like a strong dollar and historically very cheap energy prices, it's a testament to the strength of the U.S. economy that inflation is even where it is today, and that once these headwinds begin to fade, we shouldn't be surprised if inflation picks up markedly.
The majority of voting members of the FOMC don't agree with Williams' and Lockhart's view that imminent rate hikes are needed to stave off a risky bout of inflation. But that doesn't mean that markets and the Fed are in agreement.
Yellen addressed the divergent views of the market and the Fed in her Tuesday speech arguing that market-based measures of inflation, like the Cleveland Fed's are being distorted by "movements in inflation risk premiums and liquidity concerns rather than by shifts in inflation expectations." She points to survey-based measures of inflation expectations that are higher as evidence that the Fed's forecasts are accurate.
Furthermore, Yellen also sounded a dovish note on policy, saying that "developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December."
It's not a surprise, then, that the market seemed to like Yellen's remarks. Stocks were up shortly after the Fed head finished speaking. But the market should have known the fact that the Fed was thinking more cautiously about economic growth than it was in December two weeks ago. The more important conflict, though, between the Fed and markets is over where inflation is headed. And that, as Yellen's Tuesday speech showed, has yet to be resolved.