Federal Reserve Chair Janet Yellen is pressing ahead with plans to normalize monetary policy, betting that the ongoing strength of the labor market will ultimately prevail over the recent weakness in inflation.
In a press conference Wednesday after the Fed raised interest rates for the second time in 2017, Yellen played down a softening of price pressures in the last few months and voiced confidence the central bank was on course to hit its 2% inflation goal.
“It’s important not to overreact to a few readings, and data on inflation can be noisy,” she told reporters.
The decision to push forward on normalization — the Fed also provided further details of its plan to begin reducing its balance sheet this year — is not without its perils. If Yellen is wrong and inflation stays low, the Fed is in danger of having companies and consumers conclude that the central bank is not serious about hitting its price goal.
“The risk is that the Fed is too complacent on inflation and more than just transitory factors are keeping it from rising, and that the Fed is too confident about labor market improvement transitioning to wages and inflation," said Michael Gapen, chief U.S. economist at Barclays in New York.
A noted labor economist, Yellen is pinning her hopes on an ever-tightening job market eventually lifting wages and inflation — a relationship quantified in the so-called Phillips Curve that was first developed almost 60 years ago. At 4.3% in May, the unemployment rate is below the level that policy makers reckon is sustainable in the long run.
“We continue to feel that with a strong labor market and with a labor market that’s continuing to strengthen, the conditions are in place for inflation to move up," Yellen said.
Inflation in recent months, though, has been slowing, not quickening. The Fed’s favorite price gauge was 1.7% higher in April than a year ago, down from 1.9% in March and 2.1% in February. And it probably took another leg down last month, based on separate consumer price data released on Wednesday.
Yellen attributed much of the recent weakness to “one-off” factors such as a steep decline in mobile-phone costs and a drop in prescription drug prices.
Investors don’t seem to be buying that explanation. They’ve trimmed odds for a third rate hike this year to less than 50% — in spite of policy makers’ reiteration of those plans on Wednesday.
“There’s a lot of skepticism on Wall Street,” said Scott Anderson, chief economist at Bank of the West in San Francisco. “You look at market inflation expectations, and they’re moving in the opposite direction that the Fed wants them to move.”
For their part, economists began to pull forward their calls for a balance-sheet decision after Wednesday’s meeting. Economists at Citigroup Inc. joined those at Goldman Sachs Group Inc. and Morgan Stanley in looking for an announcement in September on when the wind-down begins. NatWest economists also moved up to September.
In a separate statement on Wednesday, the Fed spelled out the details of its plan to allow the balance sheet to shrink by gradually rolling off a fixed amount of assets on a monthly basis. The initial cap will be set at $10 billion a month: $6 billion from Treasuries and $4 billion from mortgage-backed securities.
The caps will increase every three months by $6 billion for Treasuries until they reach $30 billion and $4 billion for MBS until they reach $20 billion.
Officials didn’t reveal how large the portfolio might be when finished, nor the exact timing of when the process will begin this year, though Yellen told reporters it could get underway “relatively soon” if the economy performs as expected.