Janet Yellen gave her second speech of the month on Tuesday that attempted to encapsulate her’s and the Fed’s view of the state of the economy, as well as provide guidance for how the economy and Fed policy will perform in the future. It’s not clear how well the market listened.
Analysts described her speech as dovish—meanings that Fed is likely to put off future interest rate hikes—apparently based on the statement 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.”
Markets saw her comments as dovish too. According to the CME group, the probability of a rate hike by next month’s meeting fell slightly, from 28.4% to 25%.
Such movements would suggest that the market is hanging on the Fed’s every word, but this doesn’t mean that market participants actually believe in Yellen’s economic analysis or projections. As I pointed out yesterday, the market and the Federal Reserve have very different views on where inflation will go from here. The Fed sees it moving pretty quickly from today’s lows back to the Fed’s two percent target. The market, on the other hand, doesn’t see inflation rising near the Fed’s goals any time in the next decade.
But even in the short term, the market prefers to call the Fed’s bluff. While the majority of voting members of the FOMC see at least two rate hikes this year, the market is betting there’s now a 79% chance of one or fewer hikes this year. That’s up from 60% before Tuesday’s Yellen speech.
The market’s skepticism is frankly warranted here. The Federal Reserve’s record of economic projection since the end of the recession has not been great, and it has been consistently overly optimistic. It has relied on models that predict that economies generally recover to their pre-recession potential following contractions, and have had faith in the central bank’s ability to steer inflation to its goal.
But that faith in part relies on the Fed’s ability to convince markets that its monetary policy will cause the economy to the inflation and employment goals it sets, something it has failed to prove its capable of doing.
Economist Larry Summers, who was the odds on favorite to become Fed Chair until pressure from progressive groups scuttled the nomination, has argued that the Fed simply doesn’t have the tools to steer the economy back to full health, and that fiscal policy needs to step in and fill in missing demand caused by an aging population and growing income inequality, among other forces.
Though Fed chairs typically try to avoid becoming entangled in political debates in an effort to preserve the central bank’s independence, it is a bit ironic that progressive groups fought against the nomination of a man who is now advocating a more activist role for the federal government in promoting economic growth than the woman, Janet Yellen, who they seemed to prefer.