Monetary policy flexibility is Yellen's message

Outlook

Fed chief Yellen had one message yesterday—flexibility. Of course the Fed knows that once inflation gets a grip, it’s devilishly hard to reverse, she said, but the Fed is more worried about deflation than inflation at the moment. Inflation is lagging the recovery and so are wages. Therefore, lower for longer is the correct outlook, and let’s put that “next six months” remark in the context of the economic developments. We wonder if Yellen was not dampening expec-tations to fend off any untoward optimism over new data that would support the “next 6 months” story—i.e., preventing volatility.

Today’s jobless claims could be of more interest than usual. Last week, claims fell to a low of 300,000 and the 4-week average was also low at 316,000. It’s a bit early to be thinking about it, but seriously falling jobless claims may be the inspiration for talk of a really good payrolls report in May. The Bloomberg survey, however, sees a rise in initial claims by 15,000 to 315,000, so maybe not just yet.

Meanwhile, yesterday’s March industrial production (up 0.7% and Feb revised up from 0.6% to 1.2%) included the in- teresting statistic that capacity utilization reached 79.2. Analysts are impressed—it’s the highest capacity utili-zation since 2008. You remember 2008, don’t you? That’s the year the crisis started. When the Fed speaks of the output gap or “slack in the economy” that restrains inflation, capacity utilization has to be high on the list of factors. Just a thought.

It’s conceivable that rapidly improving labor market conditions and closing the output gap could speed up the recovery process faster than we thought. Yesterday Yellen admitted the Fed had been over-optimistic about recovery—just as the data may be starting to demonstrate. No sooner does the “next 6 months” story get back-burnered when real data may be putting it back on the front burner over the next 1-3 months. For some reason, the bond gang doesn’t see it that way. The 10-year yield is flattish at low levels—2.64%--when the economic data “should” be pushing it closer to 3%.

In Europe, debate is growing over “benign deflation” or “bad deflation,” as one analyst puts it. This remains the big item on the data front. At some point Draghi has to put his money where his mouth is. We think Draghi’s credibility is very high. If he says the too-high euro means more monetary accommodation is called for, he means it. Therefore, longer-term positioning would imply a falling euro against both the dollar and pound, and separately, the dollar should be get-ting some moxie from a shortening of the timeframe for the Fed—if the first green shoots are real. But we have been talking about this scenario for almost a year, so don’t hold your breath. Realistically, unless someone in Europe says something over the long Easter weekend, the FX market is going to be thin and slow until next Tuesday morning.

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