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    Feb 17 2017 - Fed Chair Yellen Lets Down Her Dovish Guard

    Fed Chair Yellen's semiannual monetary policy report to the Congress got underway today with Ms. Yellen making an appearance before the Senate Banking Committee. Her presentation was carefully calibrated, as it almost always is, yet one can make a case that she let down her dovish guard a bit.

    Some points of note include the following:

    • She reiterated her thinking that waiting too long to remove accommodation would be unwise
    • She stressed that if incoming data suggest labor market conditions continue to strengthen and inflation is moving up to 2.0%, a further adjustment of the federal funds rate would likely be appropriate
    • She pointed out that the pace of wage growth has picked up relative to its pace a few years ago, choosing not to emphasize the deceleration in wage growth seen in January
    • Her prepared remarks on the current economic situation focused more on the progress the economy has made versus the shortcomings it continues to experience
    • With the March FOMC meeting roughly a month away, she took the occasion to reiterate that every FOMC meeting should be considered a "live meeting" for a possible rate hike
    • There was an acknowledgment that the Fed would like to find a time when it can remove some of the balance sheet and that a discussion of that strategy will be had in coming months. She noted, however, that the Fed needs to see the economy on a stronger course and the normalization of the fed funds rate well under way before it could shrink the balance sheet.

    The stock market handled her commentary with great resolve, comforted perhaps by the understanding that any future adjustment in the fed funds rate would be occurring for the right reasons, namely due to stronger economic growth that would be supportive of stronger earnings growth.

    The major indices bounced back from modest losses seen in front her testimony and advanced to new record highs in the wake of her testimony.

    In listening to the Q&A portion of her testimony, we found an exchange that took place between Senator Toomey and Ms. Yellen to be an important one.

    Specifically, Senator Toomey asked Ms. Yellen why the Fed didn't really bump up its growth projections at all at the December meeting when many other bodies, like the IMF, have bumped up their 2017 growth prospects based on a belief that the implementation of fiscal stimulus in the U.S. will have a positive effect on growth.

    Ms. Yellen said most of her colleagues refrained from doing so because they wanted greater clarity on the timing, scope, and composition of any fiscal changes before making assumptions about the growth outlook.

    That's an important revelation because the Fed, without the benefit of knowing what fiscal changes will look like, still projected three rate hikes in 2017 at the December meeting. That forecast, then, is based on its view of how the economy will evolve without -- at the Fed Chair's admission -- the benefit of any fiscal stimulus.

    The assumption in the market is that fiscal stimulus will lead to stronger growth rates for the economy, so, basically, if fiscal stimulus does indeed lead to accelerated growth rates, the thinking here is that the Fed Chair all but admitted the Fed's own growth forecast will likely be too conservative.  That's important because three possible rate hikes are associated with the Fed's growth outlook based on the information it now has available to it.

    If fiscal stimulus isn't aimed at improving productivity, which can help keep inflation pressures in check, there is a risk that the Fed will find itself in a position of having to raise rates more than expected down the line -- and perhaps faster than expected -- because it isn't accounting for a meaningful acceleration in growth with its current monetary policy outlook.

    Ms. Yellen will provide a second day of testimony before the House Financial Services Committee. Her appearance there is apt to be anti-climactic since most, if not all, of the salient policy perspectives were covered in front of the Senate Banking Committee.

    The element of surprise is always present, yet it was no surprise that the Fed Chair in her appearance before the Senate Banking Committee placed an emphasis on economic progress being made. That doesn't make her a policy hawk, but in doing so, she sounded more like a dove flying at a lower altitude than before.

    --Patrick J. O'Hare, Briefing.com

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