Yellen's Testimony Dovishly Tilted

Yellen's written monetary policy testimony is dovishly tilted .  She did not diverge from previous Fedspeak about only gradually raising the funds rate and reducing the Fed's balance sheet.  But, she emphasized points made by Fed Governor Brainard: /1/ that the neutral level of the funds rate is likely low, so not much more tightening is needed, and /2/ that the Fed's main concern is the low inflation rate.  Her testimony should be a positive for prices of stocks and Treasuries.  It also suggests that Friday's report on the June CPI is the next important US economic data release.

Brainard, in a speech yesterday, reiterated that she views the "real" level of the neutral funds rate at close to 0.0%.  Adding on the Fed's 2% inflation target would put the "nominal" neutral funds rate at 2.0%.   With the current PCE Deflator inflation rate at 1.4% (y/y), the nominal neutral funds rate presumably is below 2.0% -- not far above the current 1.0-1.25% funds rate range.

Yellen said regarding the near-term neutral funds rate:

"That expectation is based on our view that the federal funds rate remains somewhat below its neutral level--that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel. Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. "

She left open a higher neutral rate in the longer term:

"But because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal. Even so, the Committee continues to anticipate that the longer-run neutral level of the federal funds rate is likely to remain below levels that prevailed in previous decades."

Yellen emphasized a very modest beginning of balance sheet reduction:

"The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb. The Committee currently expects that, provided the economy evolves broadly as anticipated, it will likely begin to implement the program this year."

Yellen said regarding inflation:

"It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices; these reductions will hold 12-month inflation down until they drop out of the calculation. Nevertheless, with inflation continuing to run below the Committee's 2 percent longer-run objective, the FOMC indicated in its June statement that it intends to carefully monitor actual and expected progress toward our symmetric inflation goal."