Janet Yellen’s testimony before the House committee was what drove markets on Wednesday. The key takeaway from the testimony was that she was moderately more dovish than she was previously. This dovishness led to a rally in stocks and bonds. The S&P 500 rallied 0.73%, the Russell 2000 increased 0.80%, and the VIX fell 5.42% to 10.30. The 10-year bond rallied as the yield fell 4.28 basis points to 2.3177%. The 2-year bond rallied as the yield fell 3.62 basis points to 1.3389%. This dovishness caused the chances of a 25-basis point hike by December to fall to 53.3% from 58.9% yesterday.

The key term of the day was the neutral rate. This is Fed speak for when the Fed will ease off the rate hike gas pedal. The neutral rate is basically the same as normalization of policy. The determination of what is normal policy is ridiculous to me because of how volatile rates have been throughout history. Normal, neutral rates now can be completely different in the next few years, if inflation and growth change, which they will. Yellen explained how monetary policy can change by saying "We're watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot appears consistent." This is why I consider the term neutral to be poor word choice.

You can look at neutral rates like a car’s gears. When a car is in neutral, on a flat terrain, the car will stay still. It’s rare for that to occur as there’s often slight inclines or declines. These changes are normal. It’s expected that every location will have different slopes, meaning the car will go forwards or backwards at different speeds when it’s in neutral. Neutral rates are low now because growth and inflation are low, which is why rate hikes have been slow. There is no true long-run inflation rate because it’s always changing. Hence calling a rate neutral doesn’t imply it’s fixed.

Part of the reason some investors viewed this moderate dovish tone from Yellen to be more powerful than it seemed is because it came of the heels of Brainard’s very dovish comments on rate hikes yesterday. This might be happenstance instead of a policy change because Brainard is usually dovish. She stated the Fed is near the neutral rate which means the rate hike cycle is near its end. That goes against the Fed’s dot plot. As you can see from the chart below, the long-run dot plot shows most agreeing that rates will go to 3.00%. The current 1.00% rate doesn’t imply we’re near the neutral rate. This wouldn’t be the first time the dot plot was wrong, but I also wouldn’t overreact to the statements and conclude a dramatic shift in policy is afoot. The rate hike at the end of the year is less important than the unwind on the balance sheet and the unwind is still happening, albeit at a gradual pace.

(Click on image to enlarge)

Another aspect at play is the fact that the Fed has been ignoring the change in inflation. This makes any dovishness get highlighted because the Fed ‘should be’ cautious on rate hikes considering the disinflation. The quote I mentioned earlier highlights that Yellen acknowledged this change which I have been highlighting for a few months. As you can see from the chart below, the PCE inflation is at 1.4% which is below the Fed’s 2% target. The ‘undershoot’ has been consistent, but it goes against the Fed’s simplistic viewpoint that low unemployment means higher inflation. This logic hasn’t worked for years, but the Fed has continued with it. This train of thinking is called the Phillips curve. The reality is compensation growth is what has an impact on inflation, not the unemployment rate which isn’t even a great measurement of the labor market.

I wouldn’t call this situation a conundrum like the chart says because the Phillips curve never was accurate. It would be happenstance if the inflation rate was pushed higher when the unemployment rate was low. This occurred shortly in late-2016 which is otherwise known as the Trump-flation. Considering that Yellen has ignored the disinflation for months, the only way to mention it without coming across as incompetent is to tacitly do so like she did. It’s important to recognize that declines in inflation don’t mean that the Fed must stop rate hikes since the Fed isn’t bound to any rules. However, if it was going to ignore inflation in policy, it still must acknowledge the changes as reality exists whether the Fed likes it or not. The ten-year breakeven inflation rate has actually increased slightly in the past few weeks. As you can see in the chart below, the rate fell to 1.66%, increased to 1.76% and is now at 1.72%.

Two interesting takes were made by CNBC contributors, which I think were worth noting. Jim Iurio stated the Fed is saying it has the market’s back because the political action on fiscal stimulus appears to be stalled. This could be true although the stock market hasn’t worried about the fiscal stimulus prospects yet, so it would be weird for the Fed to suddenly react to politics. Also, the Congress has been stalled for a few months, so this isn’t exactly news which would catalyze a change in policy.

Aaron Anderson said Yellen might want to normalize rates before she leaves in February. She would strongly denounce that publicly, but it’s human nature to want to get things in order before you leave your job. She’d probably say she doesn’t know if she’s staying in the position, but behind closed doors, she’s probably been told what’s happening. It might be a close choice between a few candidates, but it’s unlikely that she’s one of them. Starting the balance sheet reduction is great for her legacy because if it gets botched in the next few years, she can shift the blame away from herself. She is already known for starting the rate hikes, so this rate hike in September doesn’t matter to her legacy. She may want to avoid it to maintain stability in the transition period. This transition will be a real transition as the next chairperson will be much different from Yellen. The transition from Bernanke to Yellen was smooth since they both have similar schools of thought.