Yellen’s message to investors: keep calm and party on

Stockmarkets are feeling chipper again.

Investors had been getting a bit worried that the Federal Reserve might be rethinking its dovish outlook, given relatively strong economic data and a rapid stockmarket recovery following the crash that got the year off to such a thrilling start.

But Janet Yellen patted them on the head the other day, and reassured them that the Fed won't do anything to disrupt the party.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

It's party time

There's your free market right there. An exercise in taking a punt on the precise formulation of the words of one woman, and how they'll be perceived by all your fellow punters. No wonder value investing is out of fashion.

Anyway I've moaned about this more than enough in the past. What did Yellen say that got everyone so excited?

First, let's have a quick review of the past four months or so. The Fed raised interest rates by a quarter point in December. The world promptly ended. 2016 started with everything from oil to even mighty US stocks falling on their backsides.

The Fed started backpedalling rapidly. The US dollar fell back, which was good news for everything else. By the start of this month, people were starting to feel chirpy again. Time to pile into all that cyclical stuff miners, emerging markets that had been hammered in the sell-off.

But markets have been getting edgy again. The dollar stabilised. The US economic data perked up. A few Fed mouthpieces started to make noises about inflation and the Fed sticking to its planned interest rate hikes. Investors wondered if the rally had gone "too far, too fast".

So that's your backdrop for Yellen's latest speech. A relief rally on the verge of rolling over. What's she going to do when she opens her mouth?

Shore everything up, of course. Remember, the Fed's official target might be inflation or employment, but since the days of the great trickster, Alan Greenspan, its unofficial target has been the S&P 500. Basically, the stockmarket has to go up.

Why the Fed doesn't want to raise rates

First, the Fed isn't going to try negative interest rates so banks don't need to panic. Second, even if jobs data out tomorrow is strong, it doesn't mean the Fed has to raise rates. It just means that the Fed's policy is working.

Third, because of where we are at the moment, it's far easier for the Fed to raise rates quickly if economic growth and inflation surprise to the upside, than to help out if things turn worse. So the Fed will remain warier of raising too rapidly than of not acting quickly enough.

In other words, it's party time.

This might seem like the usual mealy-mouthed excuses to give the market what it wants the ones that got us into trouble before 2008. And at the end of the day, it's been a long time since anyone went bankrupt by underestimating the Fed's willingness to raise interest rates.

But I'm going to try to be fair to the Fed for a moment here. These people are not stupid. They understand the way the system works, regardless of how flawed that system is.

The US is indeed seeing a pick-up in inflation. And it might even be picking up in the likes of the eurozone (Germany returned to inflation last month).

But if you allow the strong dollar to a) force China into doing a massive devaluation of the yuan, and b) cause mass defaults on dollar-denominated debt issued by companies and governments who as per usual over-reached themselves during the good times, then you can kiss that inflation goodbye. Deflationary crunch, here we come.

Now, maybe that's what needs to happen. It's hard to clear out all the excess capacity we have in so many industries when so many of them are being kept on life support by governments or easy money or both.

But it's not the Fed's job to make that call. Indeed, this is a fundamental problem with our current way of doing things. We give central banks the responsibility for managing the economy, but without any democratic mandate to take hard decisions.

Anyway. The point is, if Yellen just sets monetary policy for local conditions, then US interest rates should be higher. But if she does that, the US dollar will rocket, and that'll create a massive deflationary wave across the world.

So, while she can't admit to it directly, the dollar exchange rate really matters if the Fed is to meet its main target, which essentially boils down to "keep the US economy on the road for now".

And her speech should certainly keep a lid on that for now. As Authers puts it: "Ms Yellen has now offered an elegant and very market friendly rationale for the Fed to wait for the data, and to err on the side of leaving monetary policy too loose."

In the longer run, that means inflation will be a problem. Be wary of bonds, and own some gold. And in the shorter run, it means stocks should continue to be supported. So stay invested.