Fed Chair Janet Yellen sends a strong signal for a December hike and gradual pace thereafter

Fed Chair Yellen opened her speech discussing the cumulative progress that has been made in achieving the Fed's dual mandate. She noted the substantial progress made in labor markets, but said the committee remains short of achieving its inflation objective. While noting the decline in the unemployment rate, to 5.0%, from its peak of 10.0% in 2009, she continues to point to cyclical softness in the participation rate and an elevated number of employees working part time for economic reasons as suggesting that the traditional unemployment rate overstates the amount of improvement. 

In her view, this excess slack has helped hold down wages and, in part, prevented a quicker return of inflation to the 2.0% mandate. Regarding inflation, the chair said the substantial declines in energy prices and the pass-through effects from a stronger dollar on import prices continue to weigh on the outlook for inflation.

Although she did not specifically mention the December meeting in terms of beginning the hiking cycle, Yellen noted that "many FOMC participants indicated in September that they anticipated, in light of economic forecasts at the time, that it would be appropriate to raise the target rate for the federal funds rate by the end of the year." She followed this by citing the October statement, which references the appropriateness of raising the policy rate once some further improvement in labor markets had been achieved and the FOMC was reasonably confident inflation would return to 2.0% over time. 

She then said "on balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market. And, as I have noted, continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2 percent objective over the medium term." Barring an extremely weak payroll print on Friday (eg, 50-75k), it is believed that conditions for a lift-off in December have been met in the eyes of the committee.

A number of factors suggest that the pace of hikes will be gradual. After strongly hinting that a rate hike in December was in store, she pivoted to the pace of hikes and, like Board Governor Lael Brainard in her speech yesterday, cited a low neutral policy rate of interest as justifying a shallow path. The neutral nominal rate of interest, which she defined as "the value of the federal funds rate that would be neither expansionary nor contractionary if the economy were operating near its potential," is estimated in various board staff studies as being low. She said the neutral rate of interest is being held down by slow potential growth, tight credit conditions, tight fiscal policy in recent years, weak growth abroad, and a stronger US dollar, among other factors. In her view, these headwinds were likely to fade in time, but there is a great deal of uncertainty about how quickly they will fade and at what pace. 

"We agree, and our own estimate of the real equilibrium rate of interest is currently near zero, and we also see it as rising gradually as headwinds to the recovery gradually fade. Hence, the committee is likely to raise the policy rate only gradually while being sensitive to what the incoming data flow says about how quickly the policy rate is rising (if at all)", notes Barclays.