Yellen's Testimony and a March Rate Hike

Any hint in Yellen's testimony that the Fed will skip hiking the funds rate in March risks triggering a short-covering rally in stocks, given how much they have fallen since Friday's Employment Report.  This reverse "buy the rumor, sell the fact" rally should not be chased, however, as Yellen is unlikely to squash the risk of a Fed rate hike in March when she presents the Semi-Annual Monetary Policy Report to the Congress on Wednesday (House) and Thursday (Senate).   This Report, formerly known as the Humphrey-Hawkins Testimony, is meant to reflect the consensus view of the FOMC -- and this view was spelled out in the January FOMC Meeting Statement.  The latter left open the door for future funds rate hikes, making the decision to do so dependent on economic and financial conditions.

The Statement said, "the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.   This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments."  The latest information is mixed, with the January Employment Report showing an above-trend increase in Payrolls (albeit slower than the Q415 pace) and a decline in the Unemployment Rate, but inflation measures and financial developments remain problematic.  Yellen will probably say there will be more evidence on the economy before the FOMC meets in March. 

The question is how she discusses the recent financial turmoil -- whether Yellen emphasizes the seriousness of the plunge in stocks or downplays it.   She could says that stocks have not fallen very far despite the heightened volatility.  Or, she could point out that other markets -- dollar and bonds -- have become more pro-growth.  This observation may come out in the question and answer part of the testimony rather than in the written testimony. 

Some Fed officials already have downplayed the relevance of the stock market drop by itself for monetary policy, saying that the fallout on the economy is what will be important.  While they are hawks, their views could have influenced the consensus view of the Committee -- which could show up in the Minutes of the January FOMC Meeting (which would be a market negative if so).  Indeed, the Fed would have a problem if it skips a rate hike in March because of the stock market sell-off -- stocks would likely drop ahead of any subsequent FOMC meeting when a rate hike is a risk, challenging the Fed to do so.  For this reason, Yellen will likely be careful not to over-emphasize the market's significance by itself.

And, as it is forward guidance, not an individual rate hike, that is the key to understanding the import of Fed policy, the markets will need to wait until the March meeting to see if Fed officials lowered their projections of the fed funds rate ahead.  Yellen's testimony will be stuck with the "dots" shown in December. 

If the stock market reacts poorly to Yellen's testimony, NY Fed President Dudley is scheduled to give a speech on Friday when he can try to limit the damage.

Carl Palash