Mellow Yellen stays the course

Expect the taper to continue. That’s what we can expect from new Federal Reserve chair Janet Yellen.

In her first public address since taking over from Ben Bernanke and becoming the first female Fed chair, Yellen delivered a predictable and colourless performance – straight from the central banking manual – which was exactly what markets wanted to hear.

Appearing before Congress on Tuesday, Yellen said that she would not make any abrupt changes to US monetary policy and that the Fed would likely continue to take further measured steps to reduce its asset purchases provided that data supports the banks expectations.

Markets reacted favourably to Yellen’s comments, which quite frankly was bizarre since her comments added nothing to what the market should have already known. Needless to say it was well known prior to the leadership change that little would change with Yellen as chair.

One important implication of Yellen’s speech is that data continues to broadly reflect the Fed’s expectations, despite the apparent slowdown in job creation in December and January. Payrolls expanded by an average of only 94,000 per month in December and January, after expanding by an average of 194,000 over 2013. The Fed is betting that this is simply temporary.

Despite recent weakness, the US labour market remains undeniably stronger than it was a year ago even if most analysts – including Yellen – would not characterise it as strong.

“By a number of measures our economy is not back, the labour market is not back to normal,” said Yellen. “There’s a great deal of slack in the labour market still.”

Indeed, while the unemployment rate slipped to 6.6 per cent in January – the lowest level since October 2008 – the participation rate remains at a remarkably low level, reflecting both an ageing population and discouraged workers. Almost four million Americans are part of the long-term unemployed, having been unemployed for over six months.

So although the US economy has made progress, there is still a long way to go, and Fed policy reflects this. The Fed continues to stimulate the economy to an extraordinary degree, even after reducing its asset purchases by US$20 billion in December and January. At no point in US history has monetary policy been so loose when the unemployment rate has been under 7 per cent.

But it can afford to do this, since inflation is of absolutely no concern for the US right now. Employment growth hasn’t resulted in wage inflation and despite an unprecedented rise in the money base it hasn’t yet translated into growth in the money supply and inflation.

For the timebeing, the Fed’s policy appears mostly appropriate. Sure, you could argue that asset purchases should be a bit lower or higher, but with inflationary pressures so benign – and likely to remain that way – there is little domestic downside to the Fed taking a measured approach.

Rather, the biggest downside to the Fed’s approach is the turmoil it has caused within emerging economies, but that won’t play any role in the Fed’s decision making process.

Yellen’s speech reiterated a number of the themes that we have come to expect from the Fed over the past six months. The Fed will move cautiously and in measured steps, it’s decisions are not set in stone, but data dependent. Its forward guidance is exactly that – guidance – and its published thresholds should not be treated as triggers.