Yellen Back In The Poole; Mishkin's Paper Is The New Playbook

Janet Yellen, President of the Federal Reserve Bank of San Francisco, gave a speech in Boise (she must be walking back from Jackson Hole)to a Community Outreach Luncheon on "Prospects for the U.S. Economy" Just as at the end of July, Yellen essentially parroted Bill Poole's (President of the St. Louis Fed) recent speech and his comments the other day on the Bloomberg. In sum, the Fed has reached the neutral rate we were guessing about once the funds rate began its climb from 1% in 1/4 point steps beginning with the June 04 meeting. With Yellen having spoken the same speech as Poole, both sides of the FOMC debate (the sides that matter) are on the same page. Neutral is neutral is neutral until the data prove it isn't.

Markets, being creatures of habit, are having a difficult time with neutral because they can't get used to the Fed making us guess the next move rather than telegraphing it.

To understand what the Fed is communicating, leaving aside whether 5.25% is right or wrong, Prof. Frederick S. Mishkin (now a FOMC member) essentially wrote the "playbook" in his paper "Can Central Bank Transparency Go Too Far". Parsing the abstract alone underscores my point.

As for what the Fed was doing when it was telegraphing the long, steady climb from extraordinary ease to neutrality:

Transparency is beneficial only when it serves to simplify communication with the public and helps generate support for central banks to conduct monetary policy optimally with an appropriate focus on long-run objectives.

He later adds:

Transparency can indeed go too far. However, central banks can improve transparency in discussing that they do care about reducing output fluctuations ... by emphasizing that monetary policy will be just as vigilant in preventing inflation from falling too low as it is from preventing it from being too high.... central banks can show that they do care about output fluctuations.

Compare this with the end of Yellen's speech today:

....while giving due consideration to the risks to economic activity....

..... policy must be responsive to the data as it emerges..... any additional firming should depend on how emerging developments affect the economic outlook....

The bottom line is this....... By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

Getting back to Mishkin's paper:

These steps to improve transparency will increase support for the central bank's policies and independence, but avoid a focus on the short run that could interfere with the ability of the central bank to do its job effectively.

Yesterday, Poole told us that future policy moves will be determined by future data that is unknown and unpredictable. Hence, it is impossible to know what the Fed will be doing next month let alone next year. Of course, he adds, ala the Mishkin prescription, that he will keep the funds rate high enough to keep inflation down.

Neutral is neutral is neutral until the data prove that it isn't.

The market still has a tiny bias that the Fed might tighten one more time this year. The December Fed funds digital options indicate a 33% chance that the Fed does something between now and the December 12 meeting with a bias (21 to 12) that the move is a hike in rates. Compared to a few trading days ago, the expectation that the Fed does nothing has risen from 60% to 67%. When the view was 60% the mix of the remaining 40% was dead even.

Looking at the market's pricing for next year, the leaning is still towards an ease, although less so. My guess is that the market is now at 40% certainty of a 100bp cumulative drop next year compared to 50% at the end of last week. The market is setting the odds of a bit better than 1 in 4 that the first drop occurs at the January 2007 meeting.

From my rudimentary calculations, if the market expectations shifted to 0% chance of any Fed actions from today on out, the yield on 2-year Treasurys would rise around 25 basis points. On the other hand, if the market prices 0% this year and gets a bit more aggressive on the ease picture for next year, the 2-year drops around 10 basis points in yield.

The risk is yours to figure based on your view of the world. But remember, the people running the world (the market world) are telling you that they don't know what is going to happen so they don't know what they are going to do. Pricing anything other than "no move" is just a guess.