Dollar, Fed Funds Traders Are Wrong, Chances of Fed Rate Hike Still 50/50

I think U.S. Dollar traders had the wrong reaction to U.S. Federal Reserve Chair Janet Yellen’s remarks on Tuesday. I was also surprised by the reaction by Fed Funds traders.

To recap, yesterday, Fed Chair Yellen said that the central bank needs to continue gradual rate hikes despite broad uncertainty about the path of inflation. It “would be imprudent to keep monetary policy on hold until inflation is back to 2 percent,” she said.

The U.S. Dollar rose on Yellen’s statements and U.S. interest rate futures prices dipped further to price in about 70 percent chance of a rate hike by December compared to near 60 percent on Monday.

The price action in the dollar and Treasury markets suggests that investors interpreted her comments to mean that soft inflation readings do not have a big bearing on Fed monetary policy. Some may have interpreted her words to mean that the Fed’s focus should not be to delay rate hikes too much to avoid having to more too fast in the future.

In reading her prepared remarkets, I focused on the following:

“My colleagues and I have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation,” Yellen said, according to prepared remarks.

With this statement, I believe Yellen raised more concerns about whether the Fed should raise rates in December. My guess is that the chances of a rate hike should still be around 50% until the central bank gets to take a look at two more months of employment and inflation data.

I also wish someone would ask her what she believes is the chance of a December rate hike instead of having speculators interpret what she is saying.

I just can’t see why the chances of a Fed rate hike jumped 10 points when all the Chair said was that trends in employment and wage price pressure have shifted from what central bank forecasters expected. I interpreted this to mean she and the Federal Open Market Committee members were wrong so why should we trust them in predicting the future.

Earlier in the month after the Fed passed on a September rate hike, the FOMC lowered its expectations for inflation ahead and said its longer-run benchmark interest rate is probably a quarter point below earlier projections.

Yellen’s lack of confidence in the Fed’s inflation projections were also clearly stated when she said, the Fed still expects longer-run inflation to trend toward the 2 percent target policymakers believe is healthy for economic growth, but the central bank is making room for the possibility that they’re wrong.

If the 2 percent target is healthy then what is an inflation rate under 2 percent, unhealthy? Also if the FOMC believes inflation will eventually reach its 2 percent goal then why lower its inflation expectations.

I have to agree with FOMC member Neel Kashkari who said earlier in the week, “The Fed should be under no pressure to raise rates. We have time to let inflation climb back to target.”