What's likely keeping Janet Yellen up at night?
Everything from market volatility to weak overseas growth to a high-priced dollar that's made U.S. exports pricier and imports cheaper, judging from the Fed chair's testimony Wednesday to Congress.
It's a rather gloomier picture compared with two months ago, when the Fed raised the short-term interest rate it controls for the first time in nearly a decade. At that time, Fed officials pointed to a healthy pace of hiring, solid consumer spending and improvement in the housing market.
In her semiannual report to Congress, Yellen spent most of her time discussing the risks to the U.S. economy, which also include less-than-optimal inflation and subpar growth in the final three months of 2015.
How likely are those trends to shape the Fed's timetable for rate increases? We asked Ryan Sweet, an economist and Fed watcher with Moody's Analytics:
Q. What's spooked the Fed since the beginning of the year?
A. There are two things: The first is the absence of any improvement in actual inflation (toward the Fed's 2 percent target). The Fed has put increased emphasis on improvements in the inflation data to justify raising rates a second time.
The other is that financial market conditions have tightened and are less supportive for growth, and I think that has created a lot of uncertainty. It's really difficult to gauge whether or not the tightening in financial markets has affected the real economy yet.
The Fed needs time to assess whether or not the drop in stock prices is affecting consumer confidence, is affecting businesses' ability to raise capital, hire and invest.
So I think that's why Yellen was a little bit wishy-washy on the path of interest rates. Her baseline forecast is still that they're going raise them very, very gradually.
Q. What do you mean by financial market conditions tightening? What does that involve? And how might it impact the broader economy?
A. First, the drop in equity prices can hurt our economy through a "negative wealth" effect: Stock prices fall, household wealth declines, people get a little bit nervous, they pull back on consumer spending.
The Fed's also worried about the dollar, because of the disinflationary effect it has on the U.S. economy. By their calculations, the appreciation of the dollar makes up almost the entire shortfall between current inflation and their 2 percent target.
The Fed's also worried about volatility in the financial markets. Volatility can hurt our economy through confidence. But it also creates uncertainty, which causes businesses to pull back on hiring and investment.
Q. Are there any downsides to Yellen's explicit reference to the stock and bond markets in her testimony?
A. The attention that Yellen gave to the strains in financial market conditions was more than we had anticipated. This risks creating a "Yellen 'put'''— offering reassurance to traders that the Fed stands ready to help markets irrespective of what is going on in the economy.
So the Fed needs to be careful in how they phrase how they're looking at financial market conditions.
Q. There's a gap between the market's view that the Fed is unlikely to hike rates this year and the forecasts of many analysts, yourself included, that the Fed could raise rates as many as two or three times in 2016. Does that mean stock prices could plummet if the Fed does raise rates?
A. Going forward, the Fed is really going to have to manage expectations well, because they don't want to surprise markets. Given that futures markets have the next rate hike out in 2017, that could be a little bit of a challenge for them. If they surprise markets, you could get a sharp sell-off in the bond market and in equities as well.
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