There are only a few individuals in the world who can move global markets with a single word.
Janet Yellen is one of them.
The Federal Reserve chairwoman will testify before Congress' Joint Economic Committee on Wednesday and then again before the Senate Budget Committee on Thursday. Then-Fed Chairman Ben Bernanke rocketed interest rates higher through the entire summer during his corresponding Capitol Hill appearance last year.
Recent Fed statements indicate that the current near-zero interest rate policy will continue for some time, while the quantitative easing programs continue to wind down.
Yellen's statements this week will undoubtedly move markets and shift investor sentiments in the short, medium, and potentially long term. Let's take a moment to survey the landscape and try to put ourselves in her shoes.
Markets on fire
Over the past few weeks the Dow Jones Industrial Average (^DJI -0.11%) and S&P 500 (^GSPC 0.02%) have each closed at all-time highs.
The two stock indexes have been propelled by a strong first-quarter earnings season. Many companies are finally seeing growth on the top line, in addition to the benefits of cost cuts to the bottom line. This is evidenced by the decline in the indexes' price-to-earnings ratios over the past year.
According to calculations by The Wall Street Journal, the Dow currently trades at 16.1 times earnings, compared to 16.4 times one year ago. The S&P has seen moved to to 17.6 times earnings today versus 18.5 last year.
As multiples have declined, the indexes have still powered to record highs. Why? The companies that make up the indexes are churning out more earnings than ever.
For Yellen, this is undoubtedly a very positive point. More earnings generated by reasons other than simple cost cuts is a great indication for future economic growth, higher productivity, and improvements in the labor markets. This earnings season points to tightening policy sooner, rather than later. Of course, there are other factors to consider.
Inflation and the labor market
Both the Consumer Price Index, or CPI, and "core" inflation measures indicate that inflation remains below the Fed's 2% target rate.
The headline CPI rate increased 0.2% in March, stronger than expected, to 1.7%. Core inflation, which excludes more volatile price changes in food and energy prices, was at 1.5%.
Most economists expect inflation to slowly rise throughout the rest of 2014, closing in on the 2% target. It is very unlikely that the Fed will raise rates until inflation rises above 2%, for fear of stoking a potentially disastrous deflationary period driven by the rate change.
That said, as the quantitative easing programs continue to taper, the yield curve will steepen and normalize. Viewing the change in the yield curve over the past year is a great example of how Yellen and the Fed will slowly transition rates higher, hoping to avoid shocking the markets.
All the while, the labor market continues to improve. Last week's jobs report was exceedingly positive, with nearly 300,000 new jobs added and a reduction in the unemployment rate to 6.3%.
With the strength in corporate America as seen in first-quarter earnings, there is no reason to expect this trend to change. As a nation, we are likely only a few quarters away from a sub-6% unemployment rate.
Growth cures all?
The one glaring weakness still holding back the economy (and likely keeping Yellen awake at night) is growth. Gross domestic product has continually disappointed since the end of the Great Recession.
The initial estimates for first quarter GDP were not pretty, indicating growth of just 0.1%. However, those numbers are subject to at least two more revisions. Tomorrow we'll see March's export figures, a critical data point that could swing the final first-quarter numbers in either direction.
Sooner or later, the economy will recover to a point that Yellen and her colleagues at the Federal Reserve will raise interest rates. Despite their dual mandate to manage employment and inflation, GDP growth will likely be the final key to unwinding the near-zero rate policy.
The markets will likely ignore the big picture in favor of specifics
After Yellen finishes her comments on Wednesday, the headlines will ignore the big picture. Instead, we'll hear pundits and commentators arguing over the right level of tapering in terms of billions of dollars of bonds per month and forecasting whether short-term rates will rise in June or July of next year.
As Yellen prepares for her big days on Capitol Hill, she's undoubtedly preparing to field the questions about the details, the planning, and the guidelines she'll employ to manage that transition in monetary policy.
But for long-term investors those details are not pertinent. What matters is the long-term health of the economy, and based on recent data and the trends that data supports, the U.S. economy remains on the right track.
