YELLOW YELLEN?

In her speech to the Economic Club of New York yesterday (3/29), Fed Chair Janet Yellen vowed to move with extreme care before tightening monetary policy in the face of lingering global deflation and trouble in China.

She swatted aside vociferous hawks on the Fed’s voting committee (FOMC), more or less pledging to flood the economy with excess stimulus in order to guarantee a safety margin against any further deflationary shocks.

Her dovish comments set off wild moves on the currency markets and a powerful relief rally on Wall Street.

The euro rose 1% to $1.13 against as traders scrambled to liquidate bets on a stronger dollar. Emerging market equities surged in hopes of another reprieve on huge dollar debts in Asia and Latin America, while gold jumped by $19 an ounce to $1,242.

Gold soars on inflation prospects Credit: KITCO

Mrs. Yellen said caution is “especially warranted” in today’s abnormal world of near zero rates because the risk of a policy mistake is asymmetric, insisting that the Fed can always catch up later relatively painlessly if inflation shoots up.

“By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero,” she said.

The current Fed rate is in a band from 0.25% to 0.50%. The median projection of the Fed governors is 0.9% by the end of 2016, implying just two more rises this year.

Mrs. Yellen is taking a major gamble holding fire since she admitted that the Fed’s key gauge of underlying inflation – Core PCE (personal consumption expenditures price index) – is now higher than she expected in December and has reached 1.7%.

She also admitted that real interest rates are currently 1.25% below their “neutral” level and that the economy is “modestly outpacing potential growth”, meaning that it is running above its long-term speed limit.

A chorus of critics have warned that the Fed is falling behind the curve as the labor market tightens and commodity prices start to firm again, fearing a repeat of the 1970s when the institution repeatedly found excuses to delay taking action on the grounds that there was still plenty of hidden slack in the economy.

“The longer the Fed dithers, the higher rates are eventually going, ” said Paul Ashworth from Capital Economics.

The Fed itself is openly split, and rebels include the San Francisco Fed chief John Williams, who warned earlier yesterday that the US labor market is tighter than it looks and that underlying inflation is building up.

He said the jobless rate of 4.9% has already dipped below the “natural rate of unemployment”, around 5% under the Fed’s model. Job vacancies have reached the highest since the dotcom boom sixteen years ago.

The US jobs market is the tightest in 16 years

Mr. Williams said cheap oil and the dollar surge have distorted the price data, masking the revival of inflationary pressures.  “When you look at the parts of the American economy that are not traded globally, like housing rents, we’re seeing prices increase in a way that reflects a stronger, tightening economy,” he said.

James Bullard from the St Louis Fed said just days ago that the next rate rise “may not be far off,” conveying an entirely different impression of Fed thinking.

“All the FOMC members seem to be swinging back and forth, probably reflecting market conditions,” said Mark Zandi from Moody’s Analytics. “Bottom line the economy is rapidly approaching full employment. Inflation is much more likely to be heading north than south.”

Mrs. Yellen has now pinned her colors to the mast, taking an unabashedly dovish position on fears that the world is a dangerous place, openly questioning whether China will be able to pull off its shift to a new growth model.

She said cheap oil should normally be a boon for the US economy. This time the effect  may have played out differently because the fall in crude prices has been so precipitous, stoking fears of a “financial tipping point” for oil exporting countries and energy firms.

The US economy has suddenly slowed

The US economy has certainly lost some momentum. The Atlanta Fed’s instant tracker of GDP growth for the first quarter has plummeted over recent weeks to 0.6%.

The risk is that the US may be drifting into incipient ‘stagflation,’ with rising inflation and tepid growth at the same time. That would be an unpleasant surprise for the Fed.  Not surprising, though, for many of Yellen’s critics.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.