US Watch – Will Yellen shift at Jackson Hole?

by: Maritza Cabezas , Georgette Boele , Roy Teo

US Watch - 18 August 2014 - Will Yellen shift at Jackson Hole.pdf ()
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  • The annual Jackson Hole Symposium has sometimes been used to signal shifts in US monetary policy.
  • We, however, expect Chair Yellen to maintain her view that labour market weakness is cyclical, which should be neutral for monetary policy.
  • Alternative scenarios, in which Ms Yellen admits even greater or less slack in the labour market, would have a larger impact on markets, but we do not think she will change her tone at this point.

The Jackson Hole Symposium and policymaking

The Jackson Hole Symposium, an annual economic conference sponsored by the Fed, gathers key central bankers and other influential participants who shape economic policymaking. In recent years, the meetings have concentrated on the global financial crisis and the role of conventional and unconventional policy instruments to mitigate the impact of the crisis. Usually, the Chairs of the Fed gives the opening speech and the conference is closely watched by financial markets. For instance, in 2010 when a number of monetary policy instruments were discussed to support the US economic recovery, yields declined and the dollar weakened as markets priced in additional monetary stimulus in the form of quantitative easing. Then, as the recovery gained ground, the interventions of the Fed Chairs became more cautious with respect to the potential for monetary easing and the impact on financial markets has become less decisive. The upcoming symposium on 21-23 August will focus on labour market dynamics. The debate is ongoing regarding the extent to which structural or cyclical factors are hindering the US labour market. Still, this issue remains crucial to monetary policy and will be decisive in determining the timing of the next rate hike. This note analyses the possible outcomes of the next Jackson Hole Symposium and their potential impact on financial markets.

The 2014 Jackson Hole Symposium: the labour market

Given the central theme of this symposium, we expect Chairwoman Yellen to revisit the topic of the role of the Fed in promoting a recovery of the job market. In the past, Ms Yellen has approached the labour market using a dashboard of indicators that aims to assess the slack of the labour market from a broader perspective than the traditional unemployment gap. This dashboard includes: payrolls growth, gross hiring rate, the job openings rate, the participation gap and nominal wage growth. Based on these indicators, Yellen has argued that much of the unemployment in the US is cyclical, which has reinforced the stance of the FOMC and the use of monetary easing to address cyclical unemployment. This is in contrast to an approach that suggests unemployment is structural and that the Fed’s efforts to create jobs would be less effective or would even result in inflationary pressure given the lack of slack in the labour market. The outcome of the Jackson Hole symposium is, of course, uncertain. However, below we present what we consider the most likely scenario (Scenario 1) and two alternatives.

Scenario 1: Yellen’s speech on labour market will stick to early line and will be neutral for markets.

During the symposium, we expect the Fed Chair’s message concerning the slack in the labour market will be neutral, leaving the essentials of the debate to academics and other policymakers. This approach suggests that she will maintain her view that the labour market weakness continues to be cyclical, highlighting weak participation and low wage growth. And it implies that interest rates would remain on hold through much of 2015. Under this scenario, market sentiment should remain constructive. The market impact will not be significant as far as the monetary policy backdrop is concerned. Financial markets have scaled back hike expectations for 2015 considerably. Although we believe that Ms Yellen will change her stance over the next few months and become less dovish, we think the Jackson Hole Symposium is too soon for such a shift. We expect the first rate hike in June 2015. There are two additional scenarios that are less likely but would have a greater impact on market sentiment:

Scenario 2: Yellen will communicate even more slack in labour market and/or some tolerance for higher inflation in near-term (dovish stance)

An alternative scenario is that the Fed Chair signals that a range of indicators are showing that there is even greater slack in the labour market, despite recent improvements in job growth and the unemployment rate. For instance, she could signal that the number of persons working part time who want to work full time remains elevated. Such a stance would lead to a further scaling back of rate hike expectations.

Jackson Hole Symposia and Market Reactions

140818-US Watch In this scenario, Treasury yields would decline further and the dollar would depreciate somewhat. High yielding and growth sensitive currencies should rally versus the USD. Of the advanced economies currencies this includes the NZD, AUD and GBP. Of the emerging market currencies this includes ZAR, RUB, BRL, TRY and IDR. But this move will be small in absolute terms. A less likely alternative under this scenario, is that Ms Yellen steps up her dovish rhetoric not by signalling more labour market slack, but by communicating the Fed is willing to accept a little more inflation in the short to medium-term to meet its labour market objectives. Indeed certain policies to reduce the slack in the labour market could heighten the risk of an inflation overshoot. The reaction of the markets in this case would depend on how convincing Ms Yellen was in keeping a lid on inflation expectations. In that case, the market reaction would be similar to the one above. If, however, there are concerns surrounding inflation, Treasury yields could even edge up and the dollar will likely depreciate more with respect to major currencies, while gold will likely outperform. That said, it seems unlikely that Chairwoman Yellen would want to send such a strong message about the optimality of an inflation overshoot at this point.

Scenario 3: Yellen changes monetary policy, acknowledging little labour market slack (hawkish stance)

If the FOMC becomes more hawkish and the Chair suggests that the timing of a rate hike has moved forward ‘significantly’ due to a strengthening economy and higher inflation, markets will interpret that the policy rate hike could occur earlier and faster than expected. Building expectations of a quicker-than-expected US rate hike should result in some softening in investor sentiment (at least in the short-term) and higher treasury yields at least in the short end. And since interest rates in most advanced economies are still at historical lows, and we don’t expect this to change, the USD should make strong gains under this scenario. Major currencies with interest rates at low levels will depreciate (JPY, AUD, EUR, NOK, SEK). As for emerging markets, the sharp appreciation of the USD, accompanied by a deterioration in sentiment, will ultimately weigh on countries that need external financing for their current accounts. This will make some emerging market currencies unattractive (ZAR, RUB, BRL, TRY, IDR). Under this scenario, we expect emerging market currencies will be more affected than those of advanced economies.