Fed's Yellen says 'high-pressure' policy may be only way back from crisis

Last Updated: Sat, Oct 15, 2016 12:59 hrs
Janet Yellan

The Federal Reserve may need to run a "high-pressure economy" to reverse damage from the crisis that depressed output, sidelined workers and risks becoming a permanent scar, Fed Chair Janet Yellen said on Friday in a broad review of where the recovery may still fall short.

Though not addressing interest rates or immediate policy concerns directly, Yellen laid out the deepening concern at the Fed that U.S. economic potential is slipping and may need aggressive steps to rebuild it.

Yellen, in a lunch address to a conference of policymakers and top academics, said the question was whether that damage can be undone "by temporarily running a 'high-pressure economy,' with robust aggregate demand and a tight labour market."

"One can certainly identify plausible ways in which this might occur," she said.

Looking for policies that would lower unemployment further and boost consumption, even at the risk of higher inflation, could convince businesses to invest, improve confidence, and bring even more workers into the economy.

Yellen's comments, while posed as questions that need more research, still add an important voice to an intensifying debate within the Fed over whether the economy is close enough to normal to need steady rate increases, or whether it remains subpar and scarred - a theory pressed by Harvard economist Lawrence Summers among others.

U.S. stocks posted further gains after Yellen's remarks while the dollar dropped. Treasury bond prices rose, pushing yields on the 2-year note to session lows.

"Maybe she is preparing for a December rate hike but she doesn't want the market to run ahead of her," said David Keeble, global head of interest rate strategy at Credit Agricole Corporate & Investment Bank. "She has moved the goal post an inch or two...She doesn’t mind more inflation."

"This is a clear rebuttal of the hawkish arguments," to raise rates soon, a line of argument centred among some of the Fed's regional bank presidents, said Christopher Low, chief economist at Ftn Financial.

Investors think the Fed is likely to raise rates in December, a nod to the country's 5 percent unemployment rate and expectations that inflation will rise.

Boston Federal Reserve Bank president Eric Rosengren, who is hosting the conference at which Yellen spoke, was one of three policymakers who dissented at the Fed's September meeting and argued for an immediate increase in rates. He feels a slight increase now will keep job growth on track and prevent a faster round of increases later.

But in a speech earlier on Friday Rosengren also referred to the economy as "nonconformist" because of its slow growth, and the general mood here was that it is driven largely by forces like aging and demographics that are unlikely to change.

"We may have to accept the reality of low growth," said John Fernald, a senior research at the San Franciso Fed. "Potential is really low."

That sort of assessment could figure importantly in coming debates over rate policy, and over whether support is building at the Fed to risk letting inflation move above its 2 percent target in order to employ more workers and perhaps encourage more investment. It could even impact the central bank's willingness to put more aggressive policies back into play if the economy slows.

"If strong economic conditions can partially reverse supply-side damage after it has occurred, then policymakers may want to aim at being more accommodative during recoveries than would be called for under the traditional view that supply is largely independent of demand," Yellen said. It would "make it even more important for policymakers to act quickly and aggressively in response to a recession, because doing so would help to reduce the depth and persistence of the downturn."

From weak inflation to the effect of low interest rates on spending, Yellen's remarks demonstrated how little in the economy has been acting as the Fed expected.

With public expectations about inflation so hard to budge, Yellen said tools like forward guidance, "may be needed again in the future, given the likelihood that the global economy may continue to experience historically low interest rates, thereby making it unlikely that reductions in short-term interest rates alone would be an adequate response to a future recession."

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