WASHINGTON, July 15, 2014 – Federal Reserve Chair Janet Yellen appeared today before the Senate Banking Committee to deliver her semiannual report on monetary policy. Among other things, she said or suggested that:
- The Fed hasn’t exhausted its ability to boost the economy with monetary policy;
- Short term interest rates will remain low;
- Even when the Fed begins to raise rates, it will be “some time” before they return to their “normal” levels;
- Inflation is below Fed targets;
- Wages are not putting any upward pressure on inflation;
- The economy is improving after a poor first quarter;
- Stocks may be over-priced.
The market response to her report so far today has been negative. Stocks initially opened high on reports of better-than-expected earnings from firms including Goldman Sachs and JPMorgan Chase, but the Dow, Standard & Poor’s 500 index, and Nasdaq all fell after Yellen’s testimony.
The Fed’s semiannual report which accompanied Yellen’s testimony observed, “Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities. Valuation metrics in some sectors do appear substantially stretched, particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”
Yellen’s comments indicated that she believes there is more that the Fed can do to boost the economy. “Too many Americans remain unemployed; inflation remains below our longer-run objective; and not all of the necessary financial reform initiatives have been completed.”
Some economists have pointed to a rapidly declining unemployment rate – 6.1 percent in June – as evidence that the labor market is returning to normal and that slack in labor supply is disappearing. On that basis they believe that the Fed should start raising short-term interest rates.
Yellen disagrees. She has made clear that she intends to keep short-term rates close to zero. She believes that there remains considerable slack in the labor supply not reflected by the unemployment rate. As the economy improves, people not counted in the unemployment figures are likely to return to the labor market.
Also at issue here is the relative stagnation of real wages. Yellen pointed out that employers still find it easy at this point to substitute capital for labor. “While rising compensation or wage growth is one sign that the labor market is healing, we are not even at the point where wages are rising at a pace that they could give rise to inflation. In fact real wages have been rising less rapidly than productivity growth; what we’ve seen is a shift in the distribution of national income away from labor and toward capital.”
Continued low inflation rates suggest to Yellen that the economy is still operating below capacity. A Fed report accompanying Yellen’s testimony observed, “With wages growing slowly and raw material prices generally flat or moving downward, firms are not facing much in the way of cost pressures that they might otherwise try to pass on.”
Before the Fed raises interest rates, Yellen wants to make sure the economy is on a “solid trajectory.” Most Fed officials expect that to occur in 2015, but Yellen says they will be watching carefully before acting. “There is no mechanical formula” for determining when the first rate hike will occur.
Senator Charles Schumer, D-N.Y., urged Yellen to “be very cautious” about raising rates. Yellen replied that the Fed will continue to keep rates low until headwinds facing the economy are completely gone. Schumer expressed pleasure with that response.
Responding to a question by Sen. Sherrod Brown, D-Ohio, Yellen said that the Fed is committed to dealing with “too-big-to-fail” financial institutions. She did not say that big banks should be broken up. Instead, the Fed is working to deal better with any failure that might occur, and to reduce the probability of a failure.
Yellen’s comments were cautious, as we have come to expect when a Fed chair testifies in Congress. She showed herself adept at straddling difficult questions, most especially the contentious question about when interest rates will rise.
Conservatives and congressional Republicans favor a strict monetary rule that will yield a definite condition for raising rates, while Democrats prefer a more wait-and-see approach. Yellen must be careful to discourage excessive risk-taking while rates are low. If she is going to reject the straitjacket of a monetary rule, she still showed that she understands the risk of keeping rates too low for too long.