Yellen: Interest Rates Will Rise This Year
For those of you responsible for anticipating the direction of interest rates, yesterday’s speech by Federal Reserve Board Chairwoman Janet Yellen is a must read. In refreshingly blunt and relatively unequivocal terms, she made it quite clear that the Fed will move to nudge up short-term interest rates by the end of the year.
After laying out the case that the slack in the labor market is gradually decreasing and likely to continue to do so and that core inflation is likely to rise over the next few years, she noted “. . .most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.”
Even as she did everything but announce a rate increase, Yellen conceded that this policy shift is not without risk and used the speech to explain to skeptics why now is the best time to raise interest rates.
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
Yellen’s speech provides the latest evidence that even as interest rates rise we are unlikely to see the type of dramatic increase in interest rates that regulators have been warning against for the last decade. A second take-away is that you should look to see what happens to bond yields today. A sharp increase in yield and maybe even a drop in the Dow Jones would demonstrate that the wizards of Wall Street have gotten Yellen’s message that this unprecedented era of easy money is coming to a close, albeit a very gradual one.