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Dudely Warns "Market's Rate Hike Expectations Are Unreasonable" Sending Yields, Dec. Odds Higher

One day after the 5th consecutive miss in US CPI, NY Fed President William Dudley threw currency and eurodollar traders for another loop when he said on Monday that it was not "unreasonable" to think that the central bank would begin trimming its balance sheet in September and sees another rate hike this year - supposedly in December - should economic data hold up, ignoring the message sent from monthly inflation reports.

In an interview with the AP, Dudely warned that "the expectations of market participants are unreasonable," when asked if the expectation of the Fed reducing its bond holdings in September was accurate. The news sent the dollar and yields higher, pushing the 10Y from 2.2050% briefly to 2.2230%, although the move was subsequently faded. The news also sent December rate hike odds modestly higher on the day, up to 33% from 25% earlier, after Dudley said that he expects another rate rise as long as economic data meets his expectations. "I would expect — I would be in favor of doing another rate hike later this year."

Despite the lack of inflation, Dudley expanded "my outlook for the economy hasn't changed materially since the beginning of the year. Continue to look for growths around 2%, slightly above trend, growth sufficient to continue to tighten the labor market. I did not raise my growth forecast after the Election because of the prospect of fiscal stimulus because I felt that there was a lot of uncertainty about how big it would be, what its composition would be, and when it would actually take effect. So, I always viewed it as a risk to the forecast. In other words, an upside risk to the forecast, but I never put it into my baseline forecast."

Pressed on inflation, the NY Fed president said "the reason why inflation won't get up to 2% very quickly on a year-over-year basis is because we've had these very low inflation readings over the last 4 or 5 months. So it's going to take time for those to sort of drop out of the year-over-year calculation."

"Now the reason why I think you'd want to continue to gradually remove monetary policy accommodation, even with inflation somewhat below target, is that 1) monetary policy is still accommodative, so the level of short-term rates is pretty low, and 2) and this is probably even more important, financial conditions have been easing rather than tightening. So despite the fact that we've raised short-term interest rates, financial conditions are easier today than they were a year ago."

Some more highlights from his interview transcript, courtesy of Bloomberg:

"The stock market's up, credit spreads have narrowed, the dollar has weakened, and those have more than offset the effects of somewhat higher short-term rates and the very modest increases that we've seen in longer-term yields."


On December hike odds, Dudley said that "If it (data) evolves in line with my expectations, I would expect -- I would be in favor of doing another rate hike later this year."


"I think that if the economy continues to grow above trend, and the labor market continues to tighten, I do think we'll get to the point where that will lead to higher wages and that will show up in terms of higher inflation."


"Now, the question is at what level of the unemployment rate will that all take place? So, if there are these secular forces that are pushing inflation lower, perhaps we can actually go to a somewhat lower unemployment rate. I would actually view -- rather than people wringing their hands that this is so awful that inflation is low, it actually might be a good thing because it could allow you to run the economy at a little bit higher level of resource utilization, which I think ... people get employed, they get job skills, they'd be able to build their human capital over time. (00:07:29) The productive capacity of the US economy would be greater -- all those things would be good things."

There was also the amusing, token take on the stock market as reflective of the current state of the economy:

"My own view is that -- I'm not particularly concerned about where our asset prices are today for a couple of reasons. The main one is that I think that the asset prices are pretty consistent with what we're seeing in terms of the actual performance of the economy."

On balance sheet reduction:

"And second of all, we can obviously announce the start of the program but delay the actual start date. So I think that -- I don't think the debt limit will have big impact on our decision about whether to start or not start the balance sheet normalization process...  It's one of the reasons why the reinvestment process, phasing that down, is going to happen very gradually, that we're not just going to stop abruptly because we want to make sure that the adjustments are small, the model is gentle, and don't have a big consequence for financial statements.So far I would say that the market reaction has been extraordinarily mild. As expectations have gone from relatively low probability that we're going to start this to a very high probability that we're going to start this relatively soon. And so that makes me more confident that when we start, it's not going to have a big consequence for financial statements."

Finally, on whether Gary Cohn will replace Janet Yellne:

"I don't want to evaluate the various candidates for the Federal Reserve, except to say that I think Gary is a reasonable candidate. He knows a lot about financial markets. He knows lots about the financial system. I don't think you have to have a PhD in Economics, which I have, to be a Chair of the Fed or Governor or a President of one of the Federal Reserve Banks."