Highlights from Fed Chair Yellen's speech

Fed Chair Janet Yellen delivered her speech on policy normalisation at the San Francisco Fed conference Friday evening. The speech repeated many of the messages from the press conference following the March FOMC meeting, but it is worth highlighting the main takeaways.

The first half of the speech explains why the FOMC finds it suitable to start raising the Fed funds rate this year. In particular, it is the improvement in labour market conditions that makes a rate hike this year appropriate. Yellen also refers to the fact that monetary policy works with a lag, which means it is too late to raise rates once both of the Fed’s objectives are met.

In particular, it is interesting that Yellen highlights that it is first and foremost further improvement in the labour market which will make her convinced that inflation is moving in direction of their 2% target. She goes on to saying that an increase in core inflation is not a precondition for her to judge that a first rate hike is warranted. Even less so is an uptick in wages because the level of wage growth consistent with full employment is highly uncertain and wage inflation is not a good indicator for consumer price growth. However, she also states that further weakening in core inflation, wages and inflation expectations would likely postpone the first rate hike. Hence, a stabilisation in various inflation measures combined with above 200,000 new jobs on average created in the coming months is likely to be the recipe for lift off this year. We continue to place the largest probability on September, but do see a risk that the hike could come earlier.

In the second half of the speech, Yellen explains why the path for the Fed funds rate following the initial hike is likely to be gradual. The main reason is that more sophisticated models, which take into account the unusually slow adjustment processes following the financial crisis, suggest that the real fed funds equilibrium rate is currently close to zero. These models also suggest that the increase in the equilibrium real rate over time is likely to be rather slow. This explains the FOMC projections showing that the unemployment rate stabilises around the projected longer-term level even though the fed funds rate remains substantially below the projected long-term neutral level.

Bottom line: the speech shows a Fed Chair that seems pretty confident that a first rate hike is coming this year but who also wants to make sure that the market understands (and prices) that the pace of hikes is likely to be gradual.