Yellen Sings A Dovish Song With Brainard

Janet Yellen’s testimony before the House committee was what drove markets on Wednesday. The key takeaway from the testimony was that she was moderately more dovish than she was previously. This dovishness led to a rally in stocks and bonds. The S&P 500 rallied 0.73%, the Russell 2000 increased 0.80%, and the VIX fell 5.42% to 10.30. The 10-year bond rallied as the yield fell 4.28 basis points to 2.3177%. The 2-year bond rallied as the yield fell 3.62 basis points to 1.3389%. This dovishness caused the chances of a 25-basis point hike by December to fall to 53.3% from 58.9% yesterday.

The key term of the day was the neutral rate. This is Fed speak for when the Fed will ease off the rate hike gas pedal. The neutral rate is basically the same as normalization of policy. The determination of what is normal policy is ridiculous to me because of how volatile rates have been throughout history. Normal, neutral rates now can be completely different in the next few years, if inflation and growth change, which they will. Yellen explained how monetary policy can change by saying “We’re watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot appears consistent.” This is why I consider the term neutral to be poor word choice.

You can look at neutral rates like a car’s gears. When a car is in neutral, on a flat terrain, the car will stay still. It’s rare for that to occur as there’s often slight inclines or declines. These changes are normal. It’s expected that every location will have different slopes, meaning the car will go forwards or backwards at different speeds when it’s in neutral. Neutral rates are low now because growth and inflation are low, which is why rate hikes have been slow. There is no true long-run inflation rate because it’s always changing. Hence calling a rate neutral doesn’t imply it’s fixed.

Part of the reason some investors viewed this moderate dovish tone from Yellen to be more powerful than it seemed is because it came of the heels of Brainard’s very dovish comments on rate hikes yesterday. This might be happenstance instead of a policy change because Brainard is usually dovish. She stated the Fed is near the neutral rate which means the rate hike cycle is near its end. That goes against the Fed’s dot plot. As you can see from the chart below, the long-run dot plot shows most agreeing that rates will go to 3.00%. The current 1.00% rate doesn’t imply we’re near the neutral rate. This wouldn’t be the first time the dot plot was wrong, but I also wouldn’t overreact to the statements and conclude a dramatic shift in policy is afoot. The rate hike at the end of the year is less important than the unwind on the balance sheet and the unwind is still happening, albeit at a gradual pace.