UPDATED: Trump’s policies could influence Fed, says Yellen

Federal Reserve Chair Janet Yellen said Tuesday that the central bank still expects to raise interest rates gradually this year. But she said the Fed also recognizes the dangers of waiting too long to tighten credit.

Testifying to Congress for the first time since President Donald Trump took office, Yellen referred implicitly to the ambitious economic program Trump has promised. She said the Fed recognizes that sharp changes in tax policy and government spending could influence the central bank’s decisions.

Yellen said “it’s too early to know what policy changes will be put in place or how their economic effects will unfold.”

Yellen testified Tuesday to the Senate Banking Committee, and she’ll testify Wednesday to the House Finances Services Committee. She’s expected to face questions about a key Republican priority, which is Trump’s desire to undo much of the Dodd-Frank financial regulatory law.

Yellen has been a staunch defender of the law, while Trump and his allies argue that the law has imposed too many constraints on banks, thereby slowing lending and economic growth.

Trump’s economic program is expected to include deep tax cuts, stimulus spending and deregulation. His initiatives are intended to achieve his goal of doubling growth to around 4%, up from the anemic 2% pace that prevailed since the Great Recession ended in 2009.

In her opening testimony, Yellen delivered a message that reflected essentially what the Fed said in its most recent policy statement on February 1, 2017: the economy and job markets have strengthened, and inflation is edging up, closer to the Fed’s 2% target.

Though the central bank still thinks rate hikes can occur slowly, Yellen added a note of caution. She said, “Waiting too long to remove accommodation would be unwise, potentially requiring the [Fed] to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”

“At our upcoming meetings,” the Fed chair said, the central bank “will evaluate whether employment and inflation are continuing to evolve in line with (the Fed’s) expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”

Yellen said she hoped any tax and spending changes would help increase worker productivity, accelerate economic growth and raise living standards.

So far, Yellen has attempted “to walk down the middle of the road” during her testimony, says Avery Shenfeld of CIBC Capital Markets in a research note. “She’s provided a nod to further tightening ahead and the risks of waiting too long, and there is a reference to the need at upcoming meetings to evaluate if the economy is evolving in a way that makes further hikes appropriate.”

Shenfeld says to note the use of the plural on “meetings.” He adds, “There was no specific allusion to a March hike in the statement, and Yellen also emphasized that hikes will be ‘gradual.'”

In December, the Fed modestly raised its benchmark short-term rate to a range of 0.5% to 0.75%, its first increase since December 2015. Until then, the Fed had left its key rate unchanged at a record low near zero for seven years to energize an economy pummelled by the most severe recession in decades. In December, the Fed also forecast that it would raise rates three times in 2017.

Many economists caution that the pace of rate increases could change quickly depending on how much success Trump has in getting his economic initiatives enacted.

Trump has said his goal is to double economic growth, as measured by the gross domestic product, from the lacklustre 2% annual rate that’s prevailed since the Great Recession ended in 2009 to a robust 4% rate or better. Comments he made late last week reiterating his commitment to major tax relief helped drive up stock indexes to fresh record highs.

But Fed officials could grow concerned that a big stimulus package at this stage of the recovery, with job growth solid and unemployment below 5%, might overheat the economy and trigger unwanted inflation pressures. If that were to happen, the central bank could decide to accelerate its rate hikes.

Beyond Dodd-Frank, Yellen could be pressed about Republican efforts to diminish the Fed’s independence, in part by subjecting it to more intensive audits. With a Republican in the White House, those efforts now stand a greater chance of success.

Trump now also has the opportunity to fill some vacancies on the Fed’s seven-member policymaking board. Daniel Tarullo, a board member who was guiding the Fed’s regulatory efforts, announced Friday that he would resign this spring.

Derek Holt, vice-president and head of Capital Markets Economics for Scotiabank, says Treasury yields spiked on the back of Yellen’s opening statement and the greenback strengthened. In a report, he says, “In my opinion, Treasury and currency markets are over-reacting and ignoring two major points, while over-emphasizing points she has previously stated. Fed fund futures pricing is little changed.”

He explains, “The first point […] markets are missing is that Yellen left her meeting references wide open […].” Holt notes no hints were given as to when a hike might come. “

He adds, “Second, Yellen did not alter reinvestment policy guidance […] There is nothing in here to suggest that the Fed will signal a change in its reinvestment policy this year, let alone implement such a change.”

Read:

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