While Janet Yellen's timetable for higher interest rates sent markets reeling, investors may have missed an important caveat: it depends on inflation.
Treasury yields jumped March 19 after Ms. Yellen said in her first press conference as Federal Reserve chair that rates could rise “around six months” after asset purchases end, most likely in the fall. At the same time, she cautioned that a decision on interest rates “depends what conditions are like.”
“Markets are not focusing enough on the conditionality,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed's division of monetary affairs from 2004 until 2008. “If inflation fails to move back up” as the Fed expects, “that's a reason to expect a later liftoff.”
Ms. Yellen's comments this week followed the release of policy makers' projections for the benchmark interest rate. The forecasts showed officials predicting the rate, now close to zero, would rise to at least 1 percent at the end of 2015, higher than their December forecast.
Yields on two-year notes, the government securities most sensitive to changes in interest-rate expectations, began to rise after the Fed released its economic projections. They jumped further after Ms. Yellen began the press conference, reaching the highest level since September and capping the biggest one-day gain since 2011.
The two-year Treasury yield was little changed late yesterday at 0.42 percent, after rising as much as 10 basis points on March 19.
In her press conference, Ms. Yellen played down the importance of the forecasts and said the outlook for inflation would influence policy makers' deliberations on interest rates.
“If we had a substantial shortfall in inflation, if inflation is persistently running below our 2 percent objective, that is a very good reason to hold the funds rate at its present range for longer,” Ms. Yellen said.
A measure of inflation watched by the Fed, the personal consumption expenditures index, rose 1.2 percent in January from a year earlier and hasn't exceeded the Fed's 2 percent goal since March 2012. Fed forecasts released after the meeting showed inflation of 1.5 percent to 1.6 percent at the end of this year and 1.5 percent to 2 percent at the end of 2015.
The Fed this week scrapped its guidance that its benchmark rate won't rise at least as long as unemployment is above 6.5 percent, so long as inflation expectations don't exceed 2.5 percent. Instead, the Fed will look at a “wide range of information” on the labor market, inflation and financial markets, Ms. Yellen said.
The Fed also announced its third straight $10 billion reduction in the monthly pace of asset purchases, to $55 billion. The central bank has signaled it will continue to taper at the same pace, meaning the end of the program would be announced in October or December.
Ms. Yellen's timetable for the first interest-rate increase accords with Fed's plans to continue tapering bond purchases in “further measured steps,” as well as policy makers' current economic forecasts.
What actually happens with the Fed's interest rate outlook “will depend on how the data unfolds,” said Mark Gertler, a New York University economist who has co-authored research with former Fed Chairman Ben S. Bernanke. “Incoming data could affect the rate decision. She was not forecasting a drop in inflation, but rather illustrating how new information about the economy could alter the Fed's plans.”
A measure of inflation that strips out more volatile food and energy costs increased 1.1 percent in January from a year earlier, the least since March 2011. It has averaged 1.4 percent over the past five years.
“If inflation has not budged by the spring, the Fed might conclude, 'We're not in a rush to move,'” said Guy Berger, a U.S. economist at RBS Securities Inc. in Stamford, Connecticut. “The last thing we want to do is cause inflation to move down. We have two mandates.”
Progress toward the second mandate -- full employment -- will no longer be linked to a specific rate of unemployment. Ms. Yellen, in her press conference, elaborated on some of the measures she will be watching.
One is the proportion of people working part-time because they can't find a full-time job, which she called “an exceptionally high number relative to the measured unemployment rate.”
Similarly, the number of long-term unemployed has been “immensely high.”
On the other hand, a decline in the participation rate, or the proportion of working-age people who either have a job or are looking for one, may “flatten out for a time, as discouraged workers start moving back into the labor market,” she said.
Other measures include the rate of hiring and the quit rate. “The dial on virtually all of those things is moving in a direction of improvement,” she said.