Interest Rates to Stay Low

Despite surprisingly good jobs numbers, the Fed will keep interest rates low for a "considerable period" beyond the end of quantitative easing.

Federal Reserve Chair Janet Yellen told lawmakers the central bank must press on with monetary stimulus as “significant slack” remains in labor markets and inflation is still below the Fed’s goal.

“A high degree of monetary policy accommodation remains appropriate,” Yellen said today in semi-annual testimony to the Senate Banking Committee. “Although the economy continues to improve, the recovery is not yet complete.”

Yellen cited labor-market weaknesses even after an unexpectedly fast decline in unemployment put pressure on Fed officials to consider accelerating their timetable for an interest-rate increase. Yellen said today that rates are likely to stay low for a “considerable period” after bond purchases end, which she said could happen following the Fed’s October meeting.

While the economy appears likely to rebound from a first-quarter contraction, Yellen said the progress “bears close watching.” Signs of labor-market slack include slow wage growth and low labor-force participation, Yellen said. Housing “has shown little recent progress” as higher mortgage rates discourage buyers.

U.S. stocks erased early gains as the Fed’s Monetary Policy Report said valuations for smaller companies in social-media and biotech industries appear “substantially stretched.”

The Standard & Poor’s 500 Index fell 0.2 percent at 10:44 a.m. in New York. The Russell 2000 Index of small companies sank 1 percent. The yield on the 10-year Treasury rose one basis point to 2.56 percent.

 

‘Mixed Signals’

“There are mixed signals concerning the economy,” Yellen said in response to questions. “We need to be careful to make sure that the economy is on a solid footing before raising interest rates.”

Unemployment fell to an almost six-year low of 6.1 percent last month, close to the level most Fed officials predicted for the end of the year. Payrolls surged by 288,000 workers, boosting the average monthly advance so far this year to almost 231,000.

Even so, some of the labor-market gauges watched by Yellen show continued weakness. The participation rate, which measures the share of working-age people in the labor force, was 62.8 percent last month, matching the lowest since 1978. Among the unemployed, about a third have been out of work for six months or longer.

Even before the latest jobs report, Federal Open Market Committee (FOMC) participants raised their projections for the level of the main interest rate over the next two years, while continuing to predict that the first increase would occur next year.

Their median estimates, released last month, called for an increase to 1.13 percent at the end of 2015 and 2.5 percent a year later. In March, they estimated that the rate would rise to 1 percent by the end of next year and 2.25 percent at the end of 2016.

Economists are predicting growth will snap back from a first-quarter contraction as an improving job outlook and stock- market gains boost consumer confidence and spending.

Gross domestic product will expand 3.1 percent from July through December following a 3.3 percent advance last quarter, according to the median forecast of 74 economists polled by Bloomberg from July 3 through July 9. It would be the first time since 2004-2005 that GDP has sustained such gains over an extended period.

“Economic activity will expand at a moderate pace over the next several years, supported by accommodative monetary policy, a waning drag from fiscal policy, the lagged effects of higher home prices and equity values, and strengthening foreign growth,” Yellen said.

A pickup in inflation toward the central bank’s 2 percent objective has also prompted some officials to say the Fed may have to consider tightening sooner. The Fed’s preferred gauge, the personal consumption expenditures index, rose 1.8 percent from a year earlier in May, the most in 19 months.

“Inflation has moved up in recent months but remains below the FOMC’s 2 percent objective for inflation over the longer run,” Yellen said.

 

Inflation ‘Noise’

Officials, including St. Louis Fed President James Bullard and Philadelphia’s Charles Plosser, have said stimulus may eventually fuel inflation beyond the Fed’s goal. Yellen at her June press conference dismissed the concern, calling recent data on price increases “noise.”

“There’s a very wide gulf between recent economic data and the Fed’s party line, which is that they’re going to hold the foot to the accelerator a bit longer,” Guy LeBas, chief fixed-income strategist in Philadelphia at Janney Montgomery Scott LLC, which oversees $11 billion in fixed-income assets, said before Yellen’s testimony. “The thing that’s going to cause the Fed to accelerate the easing timeframe is inflation risk.”

Policy makers, who have kept the benchmark interest rate near zero since December 2008 and ballooned the central bank balance sheet to a record $4.38 trillion, are beginning to plan how they will wind down their unprecedented stimulus.

The subdued expansion may warrant keeping rates low for some time even after employment and inflation are back to normal levels, Yellen said, while repeating her warning last month that the economic outlook is uncertain and rates also may need to be raised sooner.

“Decisions about the path of the federal funds rate remain dependent on our assessment of incoming information and the implications for the economic outlook,” Yellen said. Should the labor market continue improving more quickly than anticipated, rate increases “likely would occur sooner and be more rapid than currently envisioned.”

Last month, officials continued cutting the monthly pace of asset purchases for a fifth straight meeting, with a reduction of $10 billion, to $35 billion.

Officials agreed to end the purchases with a final reduction of $15 billion after their October meeting if the economy progresses as they expect, according to minutes of the June gathering released last week.

Also last month, policy makers moved closer to deciding on the main tool they will use to tighten policy when the time comes, according to the minutes.

 

Excess Reserves

Most FOMC participants agreed the interest rate on excess reserves that banks deposit at the Fed “should play a central role.” Another tool, known as the overnight reverse repurchase facility, “could play a useful supporting role,” according to the minutes.

Officials also agreed they must monitor markets for signs of froth and use supervisory measures if necessary to “address excessive risk-taking and associated financial imbalances.”

Yellen said real estate, equity, and corporate-bond valuations “remain generally in line with historical norms,” while flagging lower-rated corporate debt as a market where “valuations appear stretched.”

“We are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance,” she said.

In a monetary policy report accompanying her testimony, Fed officials said since issuing supervisory guidance on leveraged lending practices last year, “there has been strong supervisory follow-up to ensure compliance.”

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