Chair Yellen distilled the key themes for the US economy and the interest rate outlook overnight

Overnight, Chair Yellen began a two-day engagement in Washington with an address to its Economic Club (to be followed by testimony before the Joint Economic Committee tomorrow). Being the final major addresses made by Chair Yellen before the December FOMC meeting, her views on the current state of affairs and the outlook for the economy and interest rates are critical. The key theme of the address was the substantial improvement in the economy in recent years, and a belief this would continue. The FOMC's core view of continued cumulative improvement in the labour market was clearly apparent: the "unemployment rate, which peaked at 10 percent in October 2009, declined to 5 percent in October of this year near the median of FOMC participants' most recent estimates of its longer-run normal level". 

Those out of the labour force who want to work as well as those working part-time for economic reasons were not forgotten. Chair Yellen believes a further reduction in labour market slack can be facilitated in time. Continued job gains and the recent acceleration in wages growth should be supportive, encouraging greater participation; eroding remaining slack; strengthening wages; and improving the US' productive capacity. The activity narrative offered by Chair Yellen was unquestionably strong. 

The impact of the stronger US dollar and weaker global demand on net exports was noted; but, as has been the case in all recent FOMC communications, the focus of the discussion rested on domestic final purchases, which have been growing "significantly faster than real GDP", circa 3.0%. This has primarily been due to robust growth in consumption, though recent gains for housing were also highlighted. For business investment, the energy sector is a clear negative; yet outside of this, growth was (constructively) characterised as "modest". 

While the near-zero rate of annual headline inflation was noted, given the temporary deflationary energy impulse, greater emphasis continues to be placed on PCE core inflation (1.3%yr at October). Indeed, Chair Yellen then went further, highlighting that even core inflation had been impacted by weaker import prices (and perhaps indirectly by energy prices); the annual pace of "underlying inflation" was seen as "running in the vicinity of 1-1/2 to 1-3/4 percent", which is close enough to the 2% medium-term target. 

On the basis of the information above, Chair Yellen believes that "U.S. economic growth is likely to be sufficient over the next year or two to result in further improvement in the labor market [and assuming] that longer-term inflation expectations remain reasonably well anchored bolster my confidence in a return of inflation to 2 percent". Given these are the long-held conditions for a rate hike, and the market is arguably as ready as it ever will be, December looks as near a certainty as is possible. 

While Chair Yellen and the FOMC remain aware of the risks, those on the international front have "lessened since late summer" and stronger growth is anticipated hence. More broadly, the overall risks to the outlook are seen as being "very close to balanced". A final point: at the end of her speech, Chair Yellen discussed the neutral rate and longer-term interest rate expectations. The key point herein is that the (unobservable) neutral rate is historically low and will only rise slowly; consequently, the Fed Funds Rate will remain abnormally low for a long period. The uncertainty created by these abnormal circumstances and incomplete information will necessitate ongoing re-assessment of the economy.