Overreations to Friday's Fed Talk?

Two Fed speeches on Friday sparked noticeable market reactions that might have been overdone. 

Yellen conjectured that the Fed could temporarily allow "a high-pressure economy" in order to boost productivity.  The long end of the Treasury curve sold off on the inflationary implications of this scenario.

NY Fed President Dudley gave a wide-ranging interview to the NY Times in which he touched on many of the considerations and issues mentioned in prior FOMC Statements/Minutes and other Fed speeches.  The markets picked up on his expectation of a rate hike by the end of the year, and stocks came off their highs. 

There may be less than meets the eye in these comments, however: 

1.  A "high-pressure economy" is not that far different from prior Fed talk that inflation would be allowed to exceed the 2.0% target for awhile.   Also, such an economy might not be inflationary if it is successful in boosting productivity growth.  While wage growth might pick up, it would be offset by higher productivity growth so that unit labor costs would not speed up.   Moreover, her discussion was essentially theoretical and not necessarily what will be Fed policy.

The sell-off in the long end of the Treasury market after her speech very well may have been a warning sign that such a policy would backfire.  Higher long-term yields would hurt economic growth.  To be sure, from an optimal control approach to analyzing markets -- markets will move in ways to achieve the Fed's goal -- stocks could rally and the dollar fall to offset the drag from higher Treasury yields.

2.  Dudley spent a lot of time in the interview agreeing withe Brainard/Yellen contention that the strong payroll growth this year could be accommodated in a non-inflationary way as a result of more people coming back into the labor force in response to their perceptions of a improved job opportunities.  In other words, the Unemployment Rate has been steady at about 4.9% this year (5.0% in September) despite the good-sized gains in Payrolls.  Labor market capacity remained ample.

So, it was somewhat disconcerting that his expectation of rate hike this year seemed to be solely due to calendar considerations and to ignore this economic argument.  But, the two can be reconciled: Dudley may think the Unemployment Rate will decline over October-November.   In this case, however, his expectation of a rate hike does not represent any more evidence than what will be seen in the next two Employment Reports.  So, the interview should not significantly impact the probability of a December rate hike.