US Federal Reserve chair Janet Yellen has set out the case for why the Fed may allow the US economy to run hot, deepening a recent bond market rout, as traders bet the dovish central bank would tolerate higher inflation.
Long-term US government bonds sold off sharply on Friday after Dr Yellen made a case for why a "high-pressure economy" could reverse the damage of the 2008-09 great recession, such as inducing more people back into the labour force and encouraging business investment.
The yield on the 30-year US Treasury bond jumped 8 basis points to 2.56 per cent. Over the past fortnight, the yield has surged 24 basis points, the biggest two-week jump in 18 months.
Bond yields and prices are inversely related.
The savage sell off in long duration bonds has extended to Australia in recent weeks. A portfolio of AAA-rated Australian government bonds declined 0.39 per cent in September and slumped another 1.8 per cent in the first 12 days of October.
Despite the Fed planning low rates for the foreseeable future, the adjustment in long-duration bonds reflects bets that inflation could eventually break out and require higher interest rates in the long term.
In a speech in Boston, Dr Yellen spoke of the economic theory of "hysteresis", an idea that an ongoing shortfall in aggregate demand could adversely affect the supply side of the economy.
For example, in the 2008 crisis workers exited the labour market and millions of people have never returned.
"If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a high-pressure economy with robust aggregate demand and a tight labour market," Dr Yellen said.
RBC Capital Markets chief US economist Tom Porcelli said the hysteresis argument "provides cover" for dovish Fed policymakers against accelerating wage growth in the near-term.
"A dove could argue that even if wage growth - and, indeed, inflation - runs well ahead of a pace that would historically be tolerable, it also creates the opportunity to reverse the impact of hysteresis," he noted.
"Indeed, Yellen suggested that as the economy improves and people re-enter the labor force this would naturally dampen wage inflation—a supply side effect."
Dr Yellen's speech adds to evidence that the Fed is exploring new reasons to keep interest rates lower for longer.
At the conclusion of its September interest rate meeting, Dr Yellen revealed she believed that a pick up in people returning from the job market sidelines for better employment and higher wages meant the economy has "a little more room to run" than previously thought. Three of 10 Federal Open Market Committee (FOMC) members dissented on keeping rates steady.
On Friday, Dr Yellen also offered a counter-argument to her dovish stance, saying that if monetary policy remained too accommodative for too long, it "could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability."
Inflation is slowly firming in the US, but the Fed's preferred measure, the core personal consumption expenditure, currently at of 1.6 per cent, is below the Fed's 2 per cent target.
Goldman Sachs economist David Mericle warned on Friday historical forecast errors suggest that the "risks to the inflation outlook are larger than they might seem and could be especially large beyond full employment".
He noted a minority of dovish Fed policymakers had recently embraced a "whites of the eyes" approach to inflation, arguing that the Fed should delay the next rate hike until core PCE inflation is at or very close to 2 per cent.
"The strategy, or at least a softer version of it, appears to have gained momentum in recent months and even over the course of this afternoon," he wrote on Friday after Dr Yellen's speech.
He said it could "influence the pace of hikes next year and beyond."
Fed funds future pricing implies markets are betting there is about a 70 per cent chance the Fed lifts rates by December from the current Fed funds rate target band of 0.25-0.50 of a per cent
There is only an 8 per cent chance of a November rise at the Fed's meeting six days before the US presidential election, according to CME Group.
In other US economic news released on Friday, US retail sales grew a healthy 0.6 per cent in September, reversing a 0.2 per cent decline in August.
JPMorgan and Citibank reported better than expected third quarter earnings, thanks to uncertainty about the Fed's interest rate policy causing higher trading turnover in fixed income markets.
