Markets had a predictable immediate reaction to comments by Federal Reserve Chair Janet Yellen on Tuesday that they interpreted as relatively dovish signals about the thinking of the world's most important central bank.
Within minutes of her remarks, risk assets rose, government bond yields fell, the dollar weakened and the VIX declined. Sustaining this trend will require two policy signals, one short-term and one longer-term — assuming that the global economic environment remains relatively stable.
She used her much-anticipated lunchtime speech to the Economic Club of New York to paint a cautious and measured picture of the U.S. economy, and of the delicate balance that Fed policy makers must maintain.
The Fed chair acknowledged that the overall mixed U.S. picture for 2016 so far contained encouraging signs, including the continued strengthening of the labor market. Yet she also emphasized "external" risks, including slowing global economic conditions, the level of the dollar and market reactions to China's currency policy. She even recognized the influence of some structural headwinds to growth and the unusual uncertainty facing the inflationary outlook.
This cautious assessment of the economy was accompanied by a rather measured appraisal of what the Federal Reserve can do to further support growth as part of its dual mandate of maximum employment and stable inflation.
She argued that the Fed had not run out of policy ammunition and stressed the need for careful policy gradualism within a cautious approach overall — music to the ears of markets that have been conditioned to depend on the Fed to suppress financial volatility and push asset prices higher. But she also cautioned about the extent to which the central bank can continue to be effective. And she refrained from venturing into the debate about negative interest rates, which has been fueled by the decision of her counterparts in Europe and Japan to push theirs below zero.
Judging from the immediate reaction, the markets liked her overall message, which they interpreted as an indication of continued support from the Fed. Consequently, stocks and corporate bond prices rose within an overall rally for risk assets. Government bond yields fell as traders revised down their expectations of the path of future policy interest rates. The dollar depreciated as the VIX, commonly referred to as a measure of market fear, fell.
