Yellen: accommodative conditions even when interest rates rise

12 July 2017

In her semi-annual appearance before U.S. Congress, U.S. Federal Reserve chief Janet Yellen gave a prepared statement. It summarised her view of current conditions regarding employment, inflation and growth rates and the outlook for each, which was then followed by the Fed’s view of monetary policy and the Fed’s balance sheet.

There was nothing really new but she outlined her view regarding changes in the federal funds rate as economic conditions changed.  “The evolution of the economy will warrant gradual increases in the federal funds rate over time to achieve and maintain maximum employment and stable prices.” Such rises would be implemented in such a way to keep monetary policy accommodative; that is, below the neutral rate. However, she said the neutral rate was expected to rise. “But because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2% goal.” The implication is the Fed expects it can keep monetary policy accommodative while it raises the official rate.

Yellen then addressed the Fed’s balance sheet and the Fed’s intention to normalise it, beginning this year. After years of expansion caused by its quantitative easing (QE) programmes, the Fed’s balance sheet has grown from around USD$900 billion at the end of 2007 to around USD$4.5 trillion at the end of 2016. She restated how the reduction would be carried out “gradually” and starting with modest amounts so as “to limit the volume of securities that private investors will have to absorb.”

While markets have not been startled and bond yields have remained largely unchanged, ANZ’s Martin Whetton speculated as to the effects of the Fed’s implementation of its plan to shrink its balance sheet. “We think there is some logic to the argument that the asset classes that benefitted most from QE are likely to be among those that might suffer the most as it is unwound. On that score, we note that since January 2010, the S&P 500 is up 126%, the Bloomberg US Investment Grade High Yield Bond Index is up 51%, and the Bloomberg US Government Bond index is up 24%.” In other words, he thinks shares, high-grade corporate bonds and government bonds in the U.S are vulnerable.