Yellen Speech: Fed Chief Tells Congress No ‘Preset Course’ In Monetary Policy As Global Markets Hinder Rate Expectations

This story was updated at 12:42 p.m. EST.

U.S. Federal Reserve chair Janet Yellen brought a tempered message on the economy to Congress Wednesday, warning in prepared remarks that "monetary policy is by no means on a preset course." Underscoring the growing headwinds in financial markets, Yellen raised the possibility that the Fed could reverse its December decision to raise interest rates while keeping a "gradual" pace of policy tightening on the table.

Yellen's testimony comes at a particularly sensitive time for investors, with a series of financial tremors cascading through world markets in the first weeks of 2016. Fears of slower-than-expected growth out of China and plunging energy prices have sunk investors' confidence and sparked a prolonged sell-off in stocks and other assets.

Economists have notched up odds that a recession might occur in the coming year as doubts have penetrated to the fundamentals of the market. Most recently, bank stocks took a pounding as investors flagged the small but potentially damaging portion of outstanding loans made to energy companies struggling with low oil prices.

Yellen acknowledged these difficulties, noting that "financial conditions in the United States have recently become less supportive of growth," according to a transcript. "These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market," she said, before reiterating her confidence that wage gains and global economic growth will eventually bring economic conditions back to normal.

As always, Yellen emphasized the unpredictable course of the economy, reiterating that coming policy decisions would remain data-dependent. Still, she raised the possibility of a course correction. "If the economy were to disappoint, a lower path of the federal funds rate would be appropriate," Yellen said, referring to the benchmark interest rate set by the Fed.

"We want to be careful not to jump to a premature conclusion about what is in store for the U.S. economy," Yellen said in a question-and-answer session following her testimony.

Yellen's semiannual testimony to Congress provides Wall Street and the broader public insight into how the nation's top monetary policymakers are thinking, while giving the Fed chief an opportunity to telegraph coming policy moves.

When the Federal Open Market Committee lifted interest rates from virtually zero in December — the first hike since 2006 — members on the whole saw at least four more rate increases following in 2016. But the year's rocky start, together with a strengthening of the U.S. dollar against other currencies, has dimmed that outlook among several committee members.

"Certainly financial conditions have tightened, and we know that non-U.S. growth is weakening," Dallas Fed President Robert Kaplan said last week, citing the pressures from a pricier dollar, which weighs on U.S. exporters and constrains already low inflation. "We are very mindful of non-U.S. conditions, global conditions and their impact on GDP, employment and inflation."

It's not all gloomy in the economy, however. Yellen noted that the headline unemployment rate dropped to 4.9 percent in January amid indications of a more sustained rise in wages for ordinary workers. And Americans quit their jobs more frequently in January than at any time since 2008, a sign of growing confidence within the labor force.

Yellen Under Fire

After Yellen’s testimony, House committee members engaged in a stiff round of questioning and rhetorical grandstanding. Their concerns centered around the regulatory authority and transparency of the Fed, touching on issues ranging from the decision-making processes to an outstanding investigation into a leak from the regulator.

Representatives pushed Yellen on the Fed’s poorly understood practice of paying interest to banks that deposit reserves at the Fed, a practice begun in 2008 that some have cast as a multibillion-dollar gift to major banks. Yellen rejected that characterization, noting that the interest on excess bank reserves — currently set at 0.5 percent — finances the Fed’s asset holdings and allows policymakers to finely tune benchmark interest rates.

“We hold a very large stock of assets on which we are earning a substantially larger rate of returns than we are paying to the banks,” Yellen said.

By paying interest on these deposits, the Fed has been able to raise its income from assets held against the deposits. That has allowed the central bank to return some $100 billion a year back to the U.S. Treasury, five times the rate before the Fed pumped up its balance sheet.

Still, both sides of the House have grown increasingly suspicious of the Fed’s ability to hold interest-paying reserves, Guggenheim Partners analyst Jaret Seiberg said in a note to clients Wednesday. But that doesn’t make it likely to change.

“Our expectation is that interest on reserves is safe because we believe the Federal Reserve would be forced to reduce its balance sheet without this power,” Seiberg said. “That means the Federal Reserve would actually return less to Treasury, which would raise budget issues.”

Several congress members also questioned the Fed’s ability to plunge its benchmark federal funds rate below zero. With central banks from Europe to Japan lowering rates into negative territory, questions have arisen over whether a downturn would push the Fed to follow suit.

“That remains a question that we still need to examine more thoroughly,” Yellen said, adding that the legal issues had not yet been “examined thoroughly.” There were also issues of pragmatics, Yellen said, noting a 2010 internal Fed memo that questioned the ability of the Fed’s computers to handle negative federal funds rate.

“It isn’t just a question of legal authority,” Yellen added. “Could the plumbing of the financial infrastructure of the United States handle it?”

Given the political unease around the Fed’s extraordinary monetary policies of the post-crisis years, analysts at JPMorgan Chase said it was unlikely that the Fed would try to push rates negative, barring a severe economic shock.

“The Fed’s current political situation is more parlous than is the case among its overseas counterparts,” the JPMorgan analysts wrote. “The hurdle for [negative rates] in the U.S. is quite high, and we would need to see recession-like conditions before the Fed seriously considered the option.”

Yellen is scheduled to address the Senate Committee on Banking, Housing and Urban Affairs Thursday.