Yellen Testimony Strengthens Case for December Rate Hike

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Rate hike could be implemented if economic data continue to progress toward FOMC objectives

Federal Reserve Chairperson Janet Yellen, who testified before the Joint Economic Committee of Congress in Washington D.C. on November 17th, 2016, has indicated the U.S. central bank is inching closer to rising interest rates as the labor market continues to strengthen and inflation inches higher. Yellen hinted that a rate hike could be implemented soon if economic data continue to progress toward the committee’s objectives.

Yellen stated that the U.S. unemployment rate, which stood at 4.9% in October 2016, is still slightly above the Fed’s estimate for the lowest sustainable level of joblessness. However, Yellen saw some signs that a tightening labor market was beginning to produce higher wage gains, which should eventually help boost inflation to the Fed’s goal of 2%.

Source: US Bureau of Economic Analysis, Bloomberg
Source: US Bureau of Economic Analysis, Bloomberg

Yellen, who addressed Congress for the first time since Donald Trump’s victory in the presidential election on November 8th, 2016, did not touch upon prospective policies of the incoming Trump’s administration, but reiterated that future rate increases will be gradual. Bond prices have fallen and stocks have risen as investors anticipate that Trump’s proposals to cut taxes and boost infrastructure and defense spending would spur economic activities and inflation, while any dismantling of foreign trade agreements or imposition of import tariffs would be expected to hurt the U.S. economy. U.S. tech firms, most of which make their products overseas, could bear some of the brunt of any new trade restrictions.

Yellen warns of risks for not raising rates

The U.S. dollar has witnessed volatility ever since Donald Trump was elected president, fuelling expectations of major fiscal spending and sending U.S. Treasury debt yields soaring on the prospect of higher interest rates. In this regard, Yellen warned of the risks attached to waiting too long before raising rates. She said that holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and ultimately undermine financial stability.

Yellen’s remarks will serve to bolster expectations, barring a significant negative shock, for an increase in interest rates when the Federal Open Market Committee (FOMC) meets in Washington on December 13th-14th, 2016. Pricing in federal funds futures contracts imply a greater than 95% chance of a quarter-point hike. So far in 2016, Fed officials have left unchanged the target range for the benchmark federal funds rate at 0.25% to 0.5%, where it has been since December 2015, at all six meetings held, while adding that the case for raising rates had “continued to strengthen.”

Economic outlook strengthens case for rate hike

The U.S. economy has made significant progress in 2016, inching closer towards the Federal Reserve’s dual-mandate objectives of maximum employment and price stability. Job gains averaged 180,000 per month from January 2016 to October 2016, well above estimates of the pace necessary to absorb new entrants to the labor force. The unemployment rate, which stood at 4.9% in October, has held relatively steady since the beginning of the year. Moreover, the labor force participation rate has been about unchanged, despite an underlying downward trend stemming from the aging U.S. population. While the unemployment rate is still a little above the median of FOMC estimates of its longer-run level, further employment gains may well help support labor force participation as well as wage gains.

Source: Bureau of Labor Statistics
Source: Bureau of Labor Statistics

Meanwhile, U.S. economic growth appears to have picked up from its subdued pace earlier this year. After rising at an annual rate of just 1% in H1 FY16, inflation-adjusted GDP is estimated to have increased nearly 3% in Q3 FY16. In addition, consumer spending has continued to post moderate gains, supported by solid growth in real disposable income, upbeat consumer confidence, low borrowing rates, and the ongoing effects of earlier increases in household wealth. On the other hand, inflation as measured by the price index for personal consumption expenditures, increased 1-1/4% over the 12 months ended September 2016, below the FOMC’s 2% objective.

Source: US Bureau of Economic Analysis
Source: US Bureau of Economic Analysis

Near-term outlook

Encouragingly, Yellen stated that economic growth is expected to continue at a moderate pace, sufficient to generate some further strengthening in labor market conditions and a return of inflation to the Committee’s 2% objective over the next couple of years. While monetary policy remains moderately accommodative, ongoing job gains, along with low oil prices, should continue to support household purchasing power and therefore consumer spending. As the labor market strengthens further and the transitory influences holding down inflation fade, the Fed expects inflation to rise to 2%. The FOMC continues to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability.

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