Yellen leaves markets with wrong impression

Federal Reserve Chair Janet Yellen’s prepared testimony for her semi-annual report to Congress made clear that central bankers are struggling to understand the recent downward trend in inflation. Still, it is important to remember that the path of monetary policy depends not just on inflation, but also on unemployment. Yellen knows this, and it would be a mistake to interpret her comments as a dovish turn that puts in doubt the Fed’s expected policy path for the remainder of this year and in 2018.
Yellen’s prepared testimony where she highlighted the inflation issue in the context of the Fed’s forecasts: Of course, considerable uncertainty always attends the economic outlook. There is, for example, uncertainty about when — and how much — inflation will respond to tightening resource utilization.
The Fed currently attributes low inflation readings to transitory factors. Yellen reiterated this point in the prepared testimony as well as in the question-and-answer portion of the hearing, again citing a drop in cell phone prices as a particular factor. As those transitory issues wane, the Fed anticipates that low unemployment will push inflation back to its 2 percent target. Traditionalists at the Fed, including Yellen, believe that if policy makers do not tighten pre-emptively in
this environment, unemployment
will undershoot its natural rate, pushing inflation above target.
But all else is never really equal. In addition to inflation, the Fed’s reaction function includes unemployment. That adds an additional complication for policy makers. The Fed’s current policy baseline is that we have already seen the low for unemployment this year with May’s 4.3 percent reading. My assumption is that if anything, this forecast is too pessimistic and that the Fed’s growth forecasts are consistent with further declines.
Yellen will not ignore low inflation forever. The longer it lasts, the more the shortfall looks more persistent than transitory. All else equal, this would work its way into the inflation forecast, requiring a lower path of rate hikes to meet the Fed’s target.
But all else is never really equal. In addition to inflation, the Fed’s reaction function includes unemployment. That adds an additional complication for policy makers. The Fed’s current policy baseline is that we have already seen the low for unemployment this year with May’s 4.3 percent reading. My assumption is that if anything, this forecast is too pessimistic and that the Fed’s growth forecasts are
consistent with further declines.
Although the focus is currently on inflation, we shouldn’t ignore the other part of the part of the Fed’s mandate. Unemployment as well as inflation will play into the Fed’s policy decision.

—Bloomberg