Updated: 08-30-2016

Federal Reserve Chair Janet Yellen gave her much-anticipated speech on the Federal Reserve's monetary policy toolkit from Jackson Hole on Friday, August 26. The text of that speech, excluding footnotes, contained 28 long paragraphs, 249 lines, and 3,944 words. I can promise you that this perspective on her speech will be far shorter, primarily because there was only one paragraph of distinct relevance for the market.

Tooling Around

Ms. Yellen's speech could have been then most wonkish of speeches if she so chose to make it that way. She didn't, though, and that's because some of her minions put her in the tough position of looking disconnected from financial market reality if she said nothing about the economy and her view of monetary policy while providing the keynote address at the Kansas City Fed's Economic Symposium.

Her speech was entitled, The Federal Reserve's Monetary Policy Toolkit: Past, Present, and Future.

She did a nice job of laying out the approaches the Fed has taken with its monetary policy and why, and what it thinks it could still do with its toolkit to address future downturns in an environment where the long-run neutral real rate of interest is unnaturally low.

Spoiler alert:  interest on excess reserves, forward guidance, and asset purchases will remain important tools.

But enough of that wonkishness.

Here is the paragraph that served as the trading focal point for the market (emphasis our own):

Looking ahead, the FOMC expects moderate growth in real gross domestic product (GDP), additional strengthening in the labor market, and inflation rising to 2 percent over the next few years. Based on this economic outlook, the FOMC continues to anticipate that gradual increases in the federal funds rate will be appropriate over time to achieve and sustain employment and inflation near our statutory objectives. Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook.

Strength in Numbers

Ms. Yellen acknowledged that the case for a rate hike has strengthened in recent months.  Note, however, that she didn't say when she thought that next rate hike would most likely occur even in broad terms (i.e. near term, intermediate term, etc.).

Her careful presentation, balanced by the caveat in the next sentence that any rate hike moves will ultimately depend on incoming data, was undoubtedly forged by the mistake the Fed made in talking tough about the prospect of a near-term rate hike ahead of the May employment report, which pretty much blew that rate-hike notion to bits.

Recent employment data of course has been much stronger and has led some Fed officials to insinuate recently that the market is complacent in thinking the Fed's next rate hike will wait until sometime in 2017.  Now, various Fed officials would like the market to think that a rate hike could come as early as next month and that, perhaps, there will be more than one rate hike before the end of the year (more on that in a bit).

Ms. Yellen said what she said.  In effect, we think she stated the obvious given the tenor of the employment reports for June and July and the price stability of the core PCE Price Index, which has been up between 1.6% and 1.7% year-over-year for the last six months.

The Fed's dual mandate is maximum employment and price stability, yet it remains conscientious about inflation running below its objective of 2 percent.

From our vantage point, Ms. Yellen didn't walk an overtly hawkish line with her statements.  What she did was walk a steady line, preparing the market for a possible rate hike, but reserving the right not to raise rates.  Moreover, she left the certain impression that, even if the Fed did raise the fed funds rate soon, subsequent rate hikes aren't likely to be made in rapid-fire fashion since "...monetary policy is not on a preset course."

Strikingly, the capital markets moved in a fashion after the release of the speech that suggested a comfort level with the notion that the Fed is going to take its sweet time in normalizing the policy rate, including perhaps taking a pass at the September 20-21 FOMC meeting.

To that end, stocks rallied, the dollar weakened, the CBOE Volatility Index collapsed, and the front end of the Treasury yield curve sported modest price gains.  Things would change, though, with subsequent remarks from Fed Vice Chair Stanley Fischer.

Fisching for Information

In a CNBC interview following Ms. Yellen's speech, Steve Liesman asked Mr. Fischer if markets should be on the edge of their seats looking for a rate hike in September and more than one rate hike before the end of the year.  

In a rambling response, Mr. Fischer said that what the Fed Chair said in her speech is consistent with answering yes to both questions... BUT... he added that the Fed still needs to see what the incoming data will look like.

What went up/down (mostly) after Ms. Yellen's non-surprising speech went down/up (mostly) after Mr. Fischer's surprisingly candid admission on the potential policy path -- at least as he sees it.

The seesaw action was so fitting in relation to the Fed's loose lips when it come to forward guidance.

What It All Means

The fed funds futures market still isn't buying the idea of a rate hike in September, although the implied probability of a rate hike then did move up to 30% from 18% following the collective views shared by Ms. Yellen and Mr. Fischer.  The probability of the next rate hike occurring in December, meanwhile, increased to 59.3% from 51.8%.

If the August employment report ends up looking a lot like the June and July employment reports, we suspect the probability of a rate hike in September will get ratcheted up at least to a coin toss.

As it stands now, incoming data and a panoply of Fed speakers are giving the market a lot about which to think and that thought process is still an open-ended exercise.

What that means for the market most likely is that it will remain stuck in a trading vortex related to its ruminations about the Fed's next move -- or moves if some officials have it right. 

And there you have it in 28 short paragraphs, 91 lines, and 1,076 words.

--Patrick J. O'Hare, Briefing.com

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