The Fed’s Policy Pivot

Janet Yellen held her first press conference Wednesday as the new chair of the Federal Reserve and inflation was clearly on her mind. She used the word 53 times.

Yellen announced that the Fed would reduce its bond buying program, cutting another $10 billion to take the central bank’s monthly purchases down to $55 billion, with the goal of ending the program by December. She also hinted that interest rates are likely to start ticking higher sometime in the summer of 2015, running at 1 percent by the end of next year and 2.25 percent by 2016. As part of the Fed’s policy changes, Yellen also eliminated a 6.5 percent unemployment rate as the trigger before action on the Fed funds rate.

In the wake of the Yellen press conference, some analysts are arguing that the Fed dropped the unemployment target to free its hand to increase interest rates sooner rather than later. I argue the exact opposite.

Given that we seem to be at the point in the recovery cycle where discouraged workers are reentering the labor force, I suspect the unemployment rate will likely remain stuck in the mid-6 percent range for at least another several months. Yellen repeatedly asserted that inflation is continuing to run below the central bank’s target of 2 percent, which means the unemployment rate dropped faster than the Fed initially believed it would. The leaves the Fed’s policy makers unwilling to get pressured if unemployment hits that target.

The Fed chair also pointed out that forecasts can change as the data points evolve, so I doubt she and the Federal Open Market Committee are married to its rate timeline. While the markets seem to have taken the timing of interest rate increases as a certainty, plenty of flexibility remains. That’s especially true since there’s still slack in the economy in terms of utilization.

The upshot: Yellen’s press conference marks a decisive pivot in policy, as the Fed turns away from focusing primarily on improvements in the job market to an even more explicit focus on inflation. While it’s tough to imagine that, under current circumstances, we’ll reach the heights of “hyper inflation” experienced during the 1970s, we’ll probably hit over the next two years the 5 percent level experienced back in 2005, as wages begin creeping higher, rents go up and the velocity of money increases.

Other investors are coming around to that view. While Treasury Inflation Protected Securities (TIPS) posted punishing losses in 2013, their worst annual performance since 1997, yields on 10-year TIPs have fallen by more than 30 basis points so far this year to less than 0.5 percent. At the same time, yields on comparable Treasuries have fallen from 3.03 percent at the end of last year to 2.77 percent.

Purchases of exchange traded funds that purchase TIPS have also picked up, with nearly $400 million in net purchases so far this month alone. That’s the first time purchases have passed redemptions since August 2012. Clearly, the markets are getting the inflationary message.