San Francisco Fed President Yellen with an Update on the U.S. Economy

Of all the speeches since the last FOMC meeting, this speech from Janet Yellen has the most detail regarding her views on the state of the economy and the future course of monetary policy. The bottom line is that unless incoming data change the picture of the economy, rates will continue to increase. Those who are interested solely in her view of where rates are headed in the future may want to jump to the last paragraph or two:

Update on the U.S. Economy, Janet Yellen: ...I'll start by addressing some major developments in the U.S. economy relating to employment and output growth. I'll review the recent past and indicate my sense of the economy's likely path going forward, focusing particularly on risks I see relating to energy and the housing sector. Next I'll turn to the inflation picture. Finally, I'll conclude with some thoughts on the course of monetary policy in the U.S.

The part of the speech that follows this introduction repeats remarks she has made before on using fiscal policy rather than monetary policy to address the consequences of the hurricane, so I will not repeat them. The problem is that the lags in monetary policy are too long to be of much help and monetary policy cannot be directed at a particular region.  I will also add that while monetary policy can increase or decrease aggregate demand, it cannot produce oil or refineries, it cannot replace lost supply. Returning to the speech, Yellen next discusses her view of the strength of the economy and two risks to output growth in the future, higher energy costs and a fall in housing prices:

When Hurricane Katrina hit at the end of August, the economy was doing quite well. Over the preceding two and a half years, real GDP had grown steadily at, or above, its potential ... With this stretch of near or above-trend growth in economic activity, slack ... has gradually ... diminished—that is, jobs have increased by more than enough to absorb a growing workforce. ... Indeed, the latest reading on unemployment before the storm was for August, and it came in at 4.9 percent, a number that's near conventional estimates consistent with so-called "full employment." ... Evidence amassed since the storms suggests that the economy has been remarkably resilient and apt to remain on a solid track...Now to the two risks to output growth and employment that I mentioned—energy prices and housing. As I said, these were present even before Katrina struck. ...

On the risks to output growth from higher energy costs:

The outlook for trend-like growth in output that I discussed earlier incorporates noticeable effects of the energy shock on household and business spending. However, there are inevitable uncertainties about the intensity of these effects. For example, the intensity depends importantly on whether the higher prices are viewed as transitory ... or as a more permanent feature of the economic landscape. If they are seen as largely transitory, then consumers and firms typically try to maintain something close to their usual level of spending while the higher prices last ... If higher energy prices are expected to persist, however, a deeper and longer-lasting cutback in spending is more likely. To gauge perceptions concerning the permanence of higher energy prices, the natural place to look is at futures prices. Even before Katrina, ... these futures prices reflected the sense that global demand for oil would remain strong in an environment where there is little excess supply available and where geopolitical uncertainty creates risks to existing supplies... Early signs suggest that spending is holding up reasonably well in the wake of higher energy prices, although consumer confidence dropped substantially after the storms...

At this point, she repeats remarks she has made previously on risks from a housing collapse, so I won't repeat them (see Yellen: There is a Bubble But Don’t Pop It With Monetary Policy and Calculated Risk). The main message from this section is that there are risks of two types, one from the existence of a housing bubble which explains part of the increase in prices, and another from a change in the fundamentals. She notes that the long-rate conundrum is not fully understood so we cannot rule out the possibility that historical relationships will be restored, i.e. that long-term rates could rise, and that it could happen fairly quickly (but she is not predicting this will necessarily happen). Summarizing, she is wary of two big risks on the output side, problems due to high energy costs and problems due to a housing market crash, both of which relate to the Fed's goal of keeping output near full employment.

What about the Fed's other concern, inflation? Yellen says that so far, inflation and inflationary expectations are well-contained. But what about the future? A key here, something Greenspan discussed yesterday, is how much of the increase in energy costs will pass through to output prices. Yellen notes, like Greenspan, that the economy has changed considerably since the 1970s and the degree of pass through has fallen, but it isn't known with much certainty is by how much so the Fed needs to remain wary that higher input prices will eventually, after some lag, pass through to output prices. The key, she notes, is inflationary expectations since the expectation of inflation is a self-fulfilling prophecy. Here there is good news since long-term expectations have fallen by half a percent since the Fed began tightening, though medium term expectations appear to have risen. But she makes clear that the Fed must remain vigilant and not allow expectations to lose their anchor:

My focus thus far has been on ... keeping the economy ... in the vicinity of full employment. However, ... the Federal Reserve is also keenly focused on maintaining price stability. In my judgment, inflation has been relatively well-contained and essentially compatible with the Fed's price stability objective... The question for policy, of course, concerns the future, not the past. Increases in energy prices, ... are likely to continue boosting headline inflation. And a key question is whether higher energy prices also will elevate core inflation. In part, this depends on whether businesses are able to pass through higher energy and material prices or instead are forced to absorb them into the bottom line. ... Naturally, much research has gone into analyzing what happened during the 1970s, ... One of the key findings concerns the role that inflation expectations play in generating the wage-price spiral. ... the idea is that inflation expectations are like self-fulfilling prophecies. If people expect higher inflation, they will behave in ... ways that will actually generate higher inflation ... What's the evidence on people's inflation expectations? ... A recent survey taken by the University of Michigan recorded a large jump in inflation expectations over the next twelve months, and a smaller increase in longer-term expectations. But I would not read too much into this, since the short-term survey results reflect recent energy price developments ... An alternative source of information on inflation expectations comes from analyses using a ... Treasury Inflation-Protected Security ... to separate out the inflation compensation component embedded in nominal interest rates... Using this kind of analysis, ... it is notable that longer-term inflation expectations—those covering the period from five years ahead to ten years ahead—appear to have declined by half a percentage point since the Fed began tightening policy. ... However, the Federal Reserve cannot take it for granted that inflation expectations will remain well-contained. Rather, it is the job of a central bank to earn, through its actions, the public's confidence in its commitment to price stability. ...

Finally she asks if eleven rate increases is enough. She defines neutral as 3.5% - 5.5% and notes that currently rates are at the low end of that range. Because rates are at the low end of neutral, she says this causes the presumption of more rate increases. But there's no way to know for sure where neutral is (she mentions 4.5% but again cautions there is no way to know for sure), so all of it is uncertain. Yellen then says this means that incoming data will be of paramount importance.  However, she does make one thing clear, a rise in inflation is unacceptable:

Over the past sixteen months, ... the Federal Open Market Committee has ... been gradually removing the policy accommodation ... After eleven 25-basis point upward moves..., the question of exactly what constitutes a neutral stance has become more compelling. Conceptually, policy can be deemed "neutral" when the federal funds rate reaches a level that is consistent with full employment ... The neutral rate is easy to define conceptually, but it's difficult to know in practice when we're there, because estimates ... are highly uncertain and the factors influencing that rate can change over time. That said, ... I consider it reasonable to put the current neutral rate in the range of 3-1/2 to 5-1/2 percent. At 3-3/4 percent, the current federal funds rate is toward the lower end of this band. This suggests a presumption that the rate will need to be raised further. Indeed, financial markets now appear to expect the funds rate to peak at about 4½ percent... Again though, I want to emphasize that there is no way to know precisely what the neutral stance is. To my mind this means that, as the federal funds rate target nears a reasonable estimate of the neutral rate, monetary policy must become more and more dependent on incoming data relating to the strength of aggregate spending. It is equally important, of course, to monitor developments relating to inflation... One option that is clearly not on the table is allowing an unacceptable rise in inflation. It has taken many years of consistent performance for the Federal Reserve to earn the public's confidence in its commitment to price stability, and this consistency of purpose remains essential.