Forex Institutional Research: Deutsche Bank Yellen Preview
Deutsche Bank ‘Yellen: Stuck between a hike and a hard place’
Key quotes from the report:
Fed Chair Yellen’s semi-annual monetary policy testimony will be the key focus for the financial markets. Her prepared remarks will be released at 8:30 AM EST, followed by her testimony before the House Financial Services Committee at 10:00 AM. Shortly thereafter, the Q&A session will begin, and this typically lasts for a couple of hours.
Yellen will be speaking on behalf of the Committee so her prepared remarks should sound similar to the January 27 FOMC meeting statement. Still, we expect her to sound a somewhat dovish tone given the recent slowing in the economy and the dramatic tightening in financial conditions. Last quarter, real GDP grew by 0.7%, and it appears that growth will be revised down a bit from there. This quarter we project a gain of only 0.5%. Hence, the economy may narrowly escape the traditional definition of recession, which is two consecutive quarters of declining GDP.
Given Yellen’s focus on a labor-based inflation process, we do not expect the Chair to completely back away from monetary tightening this year. We have long argued that the Phillips Curve, which posits an inverse relationship between the unemployment rate and inflation, is broken. The relationship between the unemployment rate and wages is tenuous at best. The links between wages and inflation are even less clear. Nonetheless, monetary policymakers persist in arguing that low levels of unemployment will lead to higher inflation over time. Consequently, the Chair will highlight ongoing progress in the labor market. Last month, the unemployment rate fell to a new post-recession low of 4.9%, and average hourly earnings were up 2.5% over the last year, the higher end of their post-recession range.
If Yellen persists in leaving the door open for monetary tightening later this year, financial markets could react even more negatively. At the time of this writing, the fed funds futures market assigned a zero percent probability of a March rate hike, and the probability of any hikes by yearend was just under 30%. We have one rate hike in our forecast this year, in December. However, as we warned the other day, much depends on financial conditions. If they tighten further, the probability of recession, which we currently estimate at around 40%, will rise further
If it looks like the economy is turning downward, the Fed will unwind December’s rate hike and probably embark on negative rates. We would not be surprised if a House Financial Services Committee member asked Yellen what the Fed would do should the economy enter a recession. We believe the likelihood of further quantitative easing is low, because of the costs associated with an already-elevated balance sheet. Our sense is that the imposition of negative rates is a more natural evolution of extraordinary monetary-policy measures. The experiences of Europe, Japan, and Scandinavia have already provided the Fed a template for implementation
To be sure, the Fed does not yet appear to be sold on the benefits of negative rates for the US economy. Additionally, Yellen may not want to spook already skittish investors who have begun to raise concerns about the banking sector given that negative rates could further compress banks’ net interest margins. In short, while Yellen may mention that the Fed is examining negative rates as a possible contingency plan, she will likely want to reiterate to Congress that monetary policy is not a “panacea” and that ultimately the economy needs properly crafted fiscal stimulus. Unfortunately, this will not happen until the next Administration takes office, which is still some time away.
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