Fodder From The Former Fed

November 21, 2018

We recently had the opportunity to meet with Janet Yellen, the former Fed Chair, after she delivered a presentation.  Ms. Yellen touched on a large variety of topics, and given her insights and position, we thought it would be helpful to share some of those with you.  Here is what we gleaned:

Fed Moves First on Inflation

In Ms. Yellen’s opinion, the Fed can’t react to inflation when it happens.  Instead, the Fed must act beforehand.  Her main reason for this is it helps balance another critically important policy tool, which is simply the Fed’s credibility.  If the Fed has an inflation target of 2% and always lets it get higher or overshoot by a lot, then the Fed loses credibility and the market prices that risk in.  The result: higher inflation because of a self-fulfilling prophecy.  The Fed has to look ahead at where rates should be now in order to keep future inflation in check because there is a lag effect on the economy when the Fed moves rates.  A change in rates does not instantaneously change inflation, but instead nudges the course of where it will go.

The Pace is Fine

Ms. Yellen also would not slow the pace of rate increases just yet.  This is due to the above point and also the pace rates are being increased now are half of the speed they were raised in the 2004-2006 rate hike cycle.  At the time, a 0.25% increase per meeting was considered a “measured pace.”

Rates Will Be Lower

In Ms. Yellen’s mind, the potential growth of the U.S. economy is lower than it used to be.  This commonly happens to mature economies, and outside of something being done that has a permanent boost to our economic potential, she thinks this is a reality for us as well.  As far as where interest rates end up, she now views a “neutral” policy rate for the Fed at 3%.  This is lower than the 4-5% numbers we have hit historically and not much higher than the current 2-2.25%.

No Recession Yet

Expecting economic growth in 2019 to be slower than this year, Ms. Yellen does not expect a recession soon.  In fact, she still expects what she calls “above trend” economic growth next year at 2.5%.  Recessions are typically caused by one of two things: 1) Fed tightening too quickly or 2) A financial issue/bubble.  Historically, there is a 1 in 5 chance of a recession in the next year.  In her mind, we might be slightly higher than those odds right now.  However, even if we do get a recession, she doesn’t feel it needs to be deep because of our comparatively healthy starting point.

U.S. Debt Levels are Fine

The current national debt is at 77% of our GDP.  Ms. Yellen doesn’t see this as a crazy level, however, she acknowledges it isn’t low and something will have to be done about it.  One area she pointed to was entitlement spending.  This, with aging demographics, is expected to go from costing 10% of GDP to 15%.  Coupling that with rising interest rates, we will continue to have an economic headwind.  Ms. Yellen doesn’t believe radical changes will be necessary but does suggest we need some health care spending reform and Social Security modifications.

The conversation with Ms. Yellen echoed a lot of what we have been discussing at BDF.  Namely, interest rates may continue higher, the economy is still in a relatively healthy state even this far into the recovery, and inflation is being watched carefully.

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