Fed Chairwoman Janet Yellen joked in her speech today at the Economic Club of New York, “if the economy obediently followed our forecasts, the job of central bankers would be a lot easier and their speeches would be a lot shorter.” The purpose of her discussion, which she reiterated in the Q & A afterward, was “to emphasize that there can be a lot of twists and turns in the economy.” She said, “We need to be alert to what is happening in the economy and to respond to what we see happening, and not have a fixed idea that we perhaps held at some earlier time about what will come to pass.” By any measure, this is a bold departure from previous commitments under forward guidance. In her speech, she laid out the much more flexible framework implied by an environment characterized by twists and turns. (We discuss in depth here why she might be doing this).
As nebulous as the phrase ‘twists and turns’ may sound, there is actually some specificity we can put to it. The Federal Reserve Board economic model, which informs the FOMC’s forecasts, shows the various scenarios (twists and turns) as well as the baseline (dark blue line) assumptions of the members of the FOMC. What we see depicted is a fairly wide range of outcomes in unemployment, inflation and the fed funds rate. Interestingly though, the arc of each series assumes greater extremes from faster-than-expected economic growth; there aren’t a lot of scenarios where the unemployment rate rapidly rises or the inflation rate substantially drops from here but there are plenty of extreme outcomes in the other direction. This is what underpins the Fed’s increasingly urgent need for more flexibility than previous thresholds allowed for under forward guidance; the path of the fed funds rate implied by the extreme twists and turns in the other direction is simply not well digested by the market right now. By the tone of her response, Fed Chairwoman Yellen made economic thresholds and “lower for longer” sound downright old fashioned.