Skip to main content

NEW YORK (Real Money) -- What did Janet Yellen say last night? The Federal Reserve chair's speech Thursday night was a particularly interesting one for those of us that are economics geeks, as we got a rare detailed explanation of how a sitting Fed Chair thinks about inflation. But what did she say that might move markets?

Here are the three quotes I thought were more illuminating about her short- and intermediate-term plans for interest rates.

"Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy -- as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output."

Yellen comes not to bury the Philips Curve but to praise it! Essentially all she's saying here is that she still believes in neo-Keynesian orthodoxy: wage pressure should come once labor slack has been eliminated. She later insisted that there is some slack left, mostly because of elevated levels of part-time employees, but certainly seems to think the end is drawing nigh for labor slack.

"An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations."

Again, this is very much economic orthodoxy, but it is an important point. One of the reasons why the Fed is worried about inflation being persistently low is that eventually people will change their long-term expectations. Today, people who are in their early 40s or younger don't remember inflation ever being especially high.

Yellen is saying that this matters, because it influences actual inflation. Whereas inflation of 5% wouldn't have seemed odd to most working adults in the 1980s, now it would be shocking. That's a good thing. But what happens if everyone starts assuming inflation is normally around zero? It could happen if people experience such low inflation for a long period of time.

I do think the Fed's obsession with 2% specifically is somewhat odd. For most of the 1990s, Core PCE ran below 2%. Not dramatically below, but below. This may make getting to 2% specifically more difficult, per Yellen's point about inflation anchoring. But it doesn't interfere with getting close.

TheStreet Recommends

"Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2%."

Here she is saying that she thinks there will be benefits to allowing unemployment to drop below the so-called Non-Accelerating Inflation Rate of Unemployment, or NAIRU. Based on her statement above, she seems to believe that the classic relationship between the NAIRU and inflation will still hold, i.e., that once we get there with unemployment, wages and inflation should both accelerate. But she thinks we can tolerate that for a bit. She even speculates (her word) that such a move might benefit low-wage workers in particular by reversing some of the "supply shocks."

This has policy implications, to be sure. By any classic version of a monetary policy rule, the Fed should have been hiking already. (Actually, a long time ago, by most formulations). The hope that allowing us to get to full employment and even beyond might produce some benefits is part of what has caused the Fed to wait so long. That, combined with the fact that inflation expectations are well-anchored, probably has them thinking that the risks of such a policy are low, i.e., inflation isn't going to suddenly blow out if they wait too long.

The other issue, which she doesn't specifically bring up, is the question as to what the NAIRU actually is. The Fed had been thinking it was in the 5% to 5.2% area earlier this year, but now seems to think it might actually be a little below 5%. This is one of those things that we can only know once we see wages pick up. I personally think this is already happening, as on an annualized basis Average Hourly Wages are up 2.88% year to date. But I will readily admit that is nascent evidence. So we'll have to see how the data comes in over the next few months.

Once we get to the NAIRU, however, I do think the Fed's tune will change. In this speech, the Fed Chair is really making a case for why rates are likely to only rise slowly. That's not news. I think her expectations are for Fed policy to move approximately like the dots would imply once it becomes clear we've hit the NAIRU. But they might rise even slower, or not at all, until that becomes clearer.

Nothing in this speech makes me think that they will delay hiking yet again. I still expect lift-off in December. But as I've been writing, the key for traders is how policy evolves in 2016. With this, we have a pretty good view on how Yellen is thinking about inflation. While it doesn't give us a specific road map, it might help us interpret incoming data the way she will be interpreting it.

Tom Graff trades taxable fixed income for

Brown Advisory

, an independent investment advisory firm in Baltimore, Maryland.