Investors skeptical of Fed's rate policy ahead of Yellen speech

[August 23, 2016]  By Jason Lange and Lindsay Dunsmuir

WASHINGTON (Reuters) - Federal Reserve Chair Janet Yellen may struggle later this week to convince financial markets she can steer a divided U.S. central bank to raise interest rates at least once in 2016 after it started the year with four hikes on its radar.

Yellen will deliver the keynote speech at a global central banking conference in Jackson Hole, Wyoming, on Friday, an event that Fed chiefs have traditionally used to signal the direction of monetary policy.

Fed policymakers began this year with the wind at their backs, having pushed through a rate increase in December, the first such move in nearly a decade. Their forecasts at the time suggested an economy strong enough to withstand four more hikes in 2016.

But the Fed has been buffeted by a global growth slowdown, financial market volatility - first over concerns about China's economy and then later Britain's decision to quit the European Union - and choppy U.S. data.

With only three policy meetings left in the year, investors wonder whether it has dug itself into the sidelines.

"You can talk all you want but let's face it: In the last seven years we have had one measly 25-basis-point hike. Show me the money," said Don Ellenberger, a portfolio manager at Federated Investors in Pittsburgh.

Prices for Fed funds future contracts suggest investors see almost no chance for a rate increase at the September or November meetings and roughly even odds at the last meeting of the year in December.

If Yellen's Fed fails to convince Wall Street about the policy path, a rate increase could trigger financial turmoil of the sort seen in 2013, when investors were caught off guard by the central bank signaling an end to its bond-buying program.

"She has a tough job," St. Louis Federal Reserve President James Bullard told reporters last week.

Bullard, who has criticized the Fed's communications strategy as being too confusing for the public, said he was surprised the gap in expectations between the central bank and markets remained so wide.

In December 2015, investors were betting on two rate increases over the coming year compared to the four signaled by the Fed. That was roughly the same outlook each camp had a year earlier in December 2014. <FFZ5^1> <FFZ6>

The gulf is now wider, with policymakers expecting three rate increases in 2017 in addition to two hikes this year. Financial markets, however, show investors see only one rate increase from now through the end of 2017.

Federal Reserve Chair Janet Yellen attends a news conference after chairing the second day of a two-day meeting of the Federal Open Market Committee to set interest rates in Washington, DC, U.S. on June 17, 2015. REUTERS/Carlos Barria/File Photo

"We still have got this disconnect between markets and the Fed," Bullard said.

'CREDIBILITY PROBLEM'

A few Fed policymakers worry the U.S. economy, which has delivered strong job gains but worryingly weak rates of inflation, could be stuck on a low growth path that requires low rates for years as well as new policy tools. Tensions between those who believe now is the right time to hike rates and those who want to wait were apparent with the release last week of the minutes from the Fed's July 26-27 meeting.

Yellen has sought to move the Fed away from its so-called "forward guidance" approach, a communication tool that was used to provide reassurance that monetary policy would remain accommodative. The Fed's current position is that it is data-dependent, with a rate rise possible at any meeting.

The Fed had to push markets by specifically mentioning in its policy statement last October that it might raise rates at its "next meeting" in December.

Barclays economist Michael Gapen says Yellen could use her Jackson Hole speech to deliver a concrete message that a rate hike will happen in the coming months if U.S. job growth stays strong. Otherwise, investors will keep doubting future rate increases, he said.

"They question whether she will ever see data that will justify a rate hike," Gapen said. "I think she herself has a credibility problem with markets."

(Reporting by Jason Lange and Lindsay Dunsmuir in Washington; Additional reporting by Howard Schneider in Washington and Ann Saphir in San Francisco; Editing by Paul Simao)

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