Fed Chair Yellen: The outlook remains 'highly uncertain'

In a speech before The City Club of Cleveland, Federal Reserve Chair Janet Yellen sounded less dovish than she did during the press conference following the June FOMC meeting and, on balance, the minutes to the June meeting. The modest shift in tone was in line with our expectation heading into the speech, given the improved data flow since the committee met on June 16-17. That said, external risks to the US outlook have also risen since mid-June, leading her to emphasize that "the course of the economy and inflation remains highly uncertain." Her own assessment of the outlook warrants the beginning of policy normalization later this year, but we believe her assessment of the balance of risks means it wouldn't take too much to push the chair off of this view.

Chair Yellen's comments suggest she is very skeptical of the notion that residual seasonality was a significant factor in explaining the soft Q1 GDP growth outturn, saying that "statistical noise or measurement issues may have played some role." This is about the minimum the Chair could say on the subject and stands in contrast to our own analysis  and views expressed by others on the committee, including San Francisco President Williams earlier this week. She remains concerned that other factors could prove more persistent, including drags from previous dollar appreciation and oil price declines, as well as weak growth abroad, says Barclays.

Her uncertainty about the degree of economic momentum is important for the policy outlook given her view that the unemployment rate continues to understate the degree of labor market. She again pointed to the decline in labor force participation, which she believes is held down by cyclical forces. In addition, she said the number of workers employed part time for economic reasons, which amounts to 4.5% of total employment, is "notably larger" than has been the case during previous expansions. As a result, she needs to be certain that economic momentum will be sufficient to support further progress in labor markets since she sees full employment as further away than many on the committee. Her assessment that labor market slack remains elevated and allowance for factors that may prove more persistent in holding down the pace of economic growth mean that  incoming data on activity and labor markets need to be quite strong to keep her baseline policy outlook in place, particularly if global financial markets remain volatile to developments in Greece and China. We believe incoming data will be sufficiently strong and spillovers from external risks sufficiently small to warrant rate hikes beginning in September.

Support is limited for the idea that the current level of part-time employment is significantly above what can be explained by the deep recession and gradual recovery thereafter. At an estimated 680,000 shortfall relative to what its historical responsiveness to the economic cycle would imply, it is expected that, gap in part-time employment is negligible as far as its potential to influence overall labor market dynamics or the growth rate of wages. It is believed, the implementation of the Affordable Care Act could explain much of this gap. It is also believed most of the decline in participation is related to long-run demographic factors and, as a result, the participation rate is unlikely to halt the ongoing decline in the unemployment rate, notes Barclays.