PMC Weekly Review - June 24, 2016

A Macro View – When Doves Cry: A Review of the Semiannual Monetary Policy Report to the Congress

The financial markets invoke images of a zoo, with dogs of the Dow, bulls, bears, hawks, and doves. The latter two refer to the mindset of the Federal Reserve (“Fed”) regarding monetary policy. Hawks focus on inflation, and therefore prefer tighter monetary policies, like higher interest rates. Doves focus on low unemployment, and therefore favor expansionary monetary policies, such as lower interest rates. This dichotomy stems from Congress’ dual mandate for the Fed: maximum employment and price stability (or low inflation). Current Fed Chairwoman Janet Yellen was called a hawk during the economic boom in the 1990’s, but lately has been considered to be a dove. In her June 21-22 remarks, The Economic Outlook and the Fed Monetary Policy, Chairwoman Yellen neither cooed like a dove nor screeched like a hawk. Instead, she glided between conservative optimism about the economy and cautious monetary policy.

In her semiannual congressional testimony, Chairwoman Yellen stated that “the economy has made further progress toward the Federal Reserve's objective of maximum employment,” but that the pace in doing so has slowed more recently. She drew attention to irregular and low GDP, lower foreign growth due to the dollar’s strength, and weak business investments. These statements were contrasted by recognizing increased household spending and the possibility for growth in the US. Just as the domestic economic future seemed muddled, so did the international economic outlook, with concerns about China’s slowing growth and Brexit concerns. Note that in this week’s referendum Britain voted to leave the European Union. While Chairwoman Yellen stated this could cause “significant repercussions” she also stated that she doesn’t think this outcome is likely to cause a US recession. In fact, the Chairwoman notes that even though the chances of a recession in the US are low, these current economic conditions warrant cautious monetary policy.

Over the last year, the Fed’s monetary policies supported the labor market, targeted a 2% inflation rate and a federal funds rate between ¼ and ½ percent. To maintain this rate, the Fed purchased government securities in what is commonly referred to as “quantitative easing,” which led to a massive $4.5 trillion balance sheet for the Fed, which in turn requires these maturing Treasuries to preserve said rate. As investors continue to look for clues and signals that indicate future rate hikes and their timing, it seems that these increases will likely be gradual, and will be implemented over a longer term. The expectation is that the federal funds rate will be less than 1% through 2016, and less than 2% through 2017. This expectation is grounded in the hawkish sentiment that higher rates, which could strengthen the dollar against other currencies, would decrease foreign investment and domestic growth.

Nonetheless, Chairwoman Yellen stated that the Fed is carefully monitoring the labor sector, a dovish sentiment, but not fully relying on it. In short, Chairwoman Yellen’s testimony to Congress was both hawkish and dovish, as she focused on both employment and inflation. Overall, she painted a picture of a US economy that has both positives and negatives, and forecasted a Fed funds rate that will continue to remain historically low.

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