Last week I wrote that the “Shanghai Co-op” had more work to do to soothe markets following the nervous reaction to several regional Federal Reserve presidents’ hawkish utterings. Well, Fed Chair Janet Yellen, who had attended that Shanghai G-20 meeting in late February, took care of it herself in a speech the next day, on Tuesday, 29 March.
The chair’s message was loud and clear in three respects (I paraphrase her here): 1) I’m in control, rather than the regional presidents, 2) global developments from China and commodities “pose ongoing risks” and imply that we have to “proceed cautiously” in adjusting monetary policy and 3) I’m not at all convinced that the recent pickup in inflation will last, and I seriously worry about the signs of slippage in some indicators of inflation expectations.
And markets responded to her: Bond yields dropped, risk assets rallied and the broad trade-weighted U.S. dollar weakened to a five-month low, more than reversing the previous week’s gain.
Janet Yellen’s dovish message was so powerful that even the strong economic data released on Friday barely left an impression on the bond market, which puzzled many observers. The March U.S. manufacturing ISM index (and its Chinese PMI counterpart) rose back above the 50 threshold dividing expansion from contraction, signaling the end of the mild manufacturing recession. Particularly noteworthy was the surge in the ISM’s new orders component from 51.5 in February to 58.3 in March – its highest reading since November 2014, when U.S. manufacturing started to falter as oil prices slumped and the dollar appreciated.
Moreover, Friday’s labor market report showed an above-consensus 215,000 jobs gain in March, and the household survey portrayed a further rise in labor force participation, suggesting that the “reserve army of labor” has been mobilized. As a consequence, the unemployment rate ticked up to 5.0%. If the recent trend of rising labor force participation continues, the unemployment rate may stay above FOMC (Federal Open Market Committee) participants’ median estimate of NAIRU (non-accelerating inflation rate of unemployment – i.e., the unemployment rate consistent with inflation stabilizing at the Fed’s target of 2%) of 4.8% for longer than the Fed expects.
Importantly, the Fed chair seems to believe that NAIRU may be even lower than 4.8%. At least this is what footnote eight of Yellen’s 29 March speech suggests (my emphasis):
“Another risk to the inflation forecast, although one that has not changed appreciably since the turn of the year, is that the Committee may have overestimated the longer-run rate of unemployment consistent with inflation stabilizing at 2%. Currently, the median of FOMC participants’ estimates of this rate is 4.8%. However, this longer-run rate cannot be estimated precisely, and so it could be appreciably higher or lower – although given low readings on wages in recent years, I think the latter possibility is more likely than the former. If so, a lower level of unemployment might be needed to fully eliminate slack in the labor market, drive faster wage growth, and return inflation to our 2% objective.”
Thus, the job report’s combination of strong employment growth coupled with a slightly higher unemployment rate and a very modest 2.3% increase in average hourly earnings would seem to make Yellen and the Fed even less eager to remove accommodation anytime soon. In fact, ongoing accommodation will be needed to run the economy a little hot and push inflation expectations higher. Whether they read footnote eight or not, market participants seem to have heeded the message.
Joachim Fels is a PIMCO managing director and global economic advisor based in the Newport Beach, Calif., office.