Yellen says what mar­kets want to hear

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

MAR­KETS had a pre­dictable im­me­di­ate re­ac­tion to com­ments by Fed­eral Re­serve Chair Janet Yellen on Tues­day that they in­ter­preted as rel­a­tively dovish sig­nals about the think­ing of the world's most im­por­tant cen­tral bank. Within min­utes of her re­marks, risk as­sets rose, gov­ern­ment bond yields fell, the dol­lar weak­ened and the VIX de­clined. Sus­tain­ing this trend will re­quire two pol­icy sig­nals, one short-term and one longer-term -- as­sum­ing that the global eco­nomic en­vi­ron­ment re­mains rel­a­tively sta­ble.

She used her much-an­tic­i­pated lunchtime speech to the Eco­nomic Club of New York to paint a cau­tious and mea­sured pic­ture of the U.S. econ­omy, and of the del­i­cate bal­ance that Fed pol­icy mak­ers must main­tain.

The Fed chair ac­knowl­edged that the over­all mixed U.S. pic­ture for 2016 so far con­tained en­cour­ag­ing signs, in­clud­ing the con­tin­ued strength­en­ing of the la­bor mar­ket. Yet she also em­pha­sized "ex­ter­nal" risks, in­clud­ing slow­ing global eco­nomic con­di­tions, the level of the dol­lar and mar­ket re­ac­tions to China's cur­rency pol­icy. She even rec­og­nized the in­flu­ence of some struc­tural head­winds to growth and the un­usual un­cer­tainty fac­ing the in­fla­tion­ary outlook.

This cau­tious as­sess­ment of the econ­omy was ac­com­pa­nied by a rather mea­sured ap­praisal of what the Fed­eral Re­serve can do to fur­ther sup­port growth as part of its dual­man­date of max­i­mum em­ploy­ment and sta­ble in­fla­tion.

She ar­gued that the Fed had not run out of pol­icy am­mu­ni­tion and stressed the need for care­ful pol­icy grad­u­al­ism within a cau­tious ap­proach over­all -- mu­sic to the ears of mar­kets that have been con­di­tioned to de­pend on the Fed to sup­press fi­nan­cial volatil­ity and push as­set prices higher. But she also cau­tioned about the ex­tent to which the cen­tral bank can con­tinue to be ef­fec­tive. And she re­frained from ven­tur­ing into the de­bate about neg­a­tive in­ter­est rates, which has been fu­eled by the de­ci­sion of her coun­ter­parts in Europe and Ja­pan to push theirs be­low zero.

Judg­ing from the im­me­di­ate re­ac­tion, the mar­kets liked her over­all mes­sage, which they in­ter­preted as an in­di­ca­tion of con­tin­ued sup­port from the Fed. Con­se­quently, stocks and cor­po­rate bond prices rose within an over­all rally for risk as­sets. Gov­ern­ment bond yields fell as traders re­vised down their ex­pec­ta­tions of the path of fu­ture pol­icy in­ter­est rates. The dol­lar de­pre­ci­ated as the VIX, com­monly re­ferred to as a mea­sure of mar­ket fear, fell.

Sus­tain­ing this move­ment in the short­term will re­quire Yellen's mes­sage to be sup­ported by her Fed col­leagues in the next few days. This is far from cer­tain.

The mixed eco­nomic sig­nals, along with con­cerns about the col­lat­eral dam­age to mar­kets and the econ­omy caused by the con­tin­ued ex­ces­sive re­liance on ex­cep­tional Fed poli­cies, have led some U.S. cen­tral bank of­fi­cials to give a more cau­tious mes­sage in the last week. Some even ap­peared to sug­gest that a rate hike in April was a real pos­si­bil­ity.

Over the longer term, the chal­lenge takes on an added di­men­sion. Even if the Fed is will­ing to con­tinue to its ex­cep­tional sup­port to mar­kets as a way to stim­u­late the econ­omy, the ef­fec­tive­ness of this ap­proach is far from as­sured. And this does not re­late only to the de­clin­ing ben­e­fits of a pol­icy that has been in place for much longer than any­one en­vis­aged. There also are ris­ing con­cerns about the un­in­tended con­se­quences of the Fed's "only-gamein-town" sta­tus, in­clud­ing what it im­plies for fu­ture fi­nan­cial sta­bil­ity.

Fi­nally, and per­haps most im­por­tantly for the well-be­ing of both the U.S. and global economies, the big­gest take­away from Yellen's im­por­tant speech could go be­yond the spe­cific is­sues she cov­ered. Her re­marks and their con­text could be taken to sug­gest that, for rea­sons be­yond its con­trol, the Fed is in­creas­ingly held hostage by three forces that could threaten its own cred­i­bil­ity and po­lit­i­cal au­ton­omy:

Politi­cians who re­peat­edly fail to take ad­van­tage of the time the Fed buys for them, with­hold­ing a much-needed com­pre­hen­sive pol­icy re­sponse to the cycli­cal and struc­tural chal­lenges to the U.S. econ­omy, as well as lim­it­ing Amer­ica's abil­ity to have a lead­er­ship role in global pol­icy co­or­di­na­tion.

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