Markets still aren't convinced Fed chair Janet Yellen will keep raising rates: Don Pittis

Just over a week agothe world's most powerful central banker Janet Yellen gave her clearest signal yet that she would raiseinterest rates this week.

"Afurther adjustment of the federal funds rate would likely be appropriate," the Federal Reserve chairsaid in a much-quoted portion of her speech.

Some commentators, includingcentral banking scholar SebastianMallaby, think raising rates by a quarter-point is not enough. Last weekMallaby, winner of the 2016 Financial Times book of the year,reiterated his recommendation thatYellenshould double down and increase interest rates by a half a percentage point toforcethe markets into paying attention.

Repeated warnings

Yet despite repeated warningsfrom Yellen of three quarter-point interestrate rises in 2017, market traders seem to be hardly reacting. In the first months of the year, the Dow Jones industrialaveragehas passedthrough 20,000 and then 21,000 with only a small retreat.

• Janet Yellen hints at March rate hike and more to come
• Ratehikes likely to be gradual, Janet Yellen tells U.S. lawmakers

Of course one reasonmarkets keep climbing maybe that traders really think the economy is on a breakaway.

Whether based on irrational euphoria or concrete evidence, under thatscenario,the market has decidedthat U.S. President Donald Trump's promisedtax cuts, deregulation and stimulus spendingwill overcome the impact of a whole series of rate rises.

In the business press, the assumption everywhere is that a rate rise this Wednesday is inevitable. Bondinterest rates have swept higher. On Friday, jobs numbers in both the U.S. and Canada showed unemployment low and jobs growing.

So why would anyone think that Yellen and her advisers would threaten to raise interest rates sharply and then fail to do it?

Well, for one thing, she's done it before. Repeatedly.

More costly borrowing

It wasn't so long ago that Yellen stood up in front of reporters and announced that the Fed was expecting fourquarter-point increases (moves of 25 basis points each) annually.

"Participants are projecting of course, there's a lot of uncertainty but they're projecting increases that average around 100 basis points per year," said Yellenin June 2015.

That kind of rise in interest rates is not to be sneezed at. Deals based on borrowing attwo or three per cent look distinctly different at four or five per cent.

As we reported at the time,rate increases of that magnitudewould have an impact far beyond the U.S. As higher interest rates inevitably creep across the border into Canada, all of a sudden Canadian mortgagesand other loans begin to look pricey.

However, in the more thana year and a half since that pronouncement by Yellen, there was a single quarter-point rise in 2015 and another at the end of 2016.

Unfired gun

Yellen'sjustification for not raising rates despite repeatedforecastsis that conditions havechanged.

But it's not as if the warnings have not had an effect. Just as Canadian homebuyers are forced to take future rate rises into account when deciding how much house they can afford, the simple threat of rateincreases alters the market.

Like amissile in its silo or an unfired gun, such athreat has its own unique power.

Perhaps we can picture Yellen(wearing a slouch fedora?) holding hersmall gun on a room full of market traders.

"I really mean it. I'm tellingyou, I'll do it," Yellen would say.

As we have seen repeatedly, including following last week's speech, warningshave a direct effect on bondrates without the Fed taking any action at all. As with the Canadian homebuyer, higher bond rates and the expectation of future increases have a restraining effect on the economy.

And there are reasons why a threat can be better than action.

Although the economy seems to be strengthening, there are still no signs of a full-fledged post-crash boom typical of previous recoveries. Headline inflation has been higher, pushed by rising energy prices, but as we saw last week when oil crashed by five per cent in a day, headline inflation can be volatile.

There are widespread fears that markets are overvalued and could be teetering on the verge of a new decline.

A sharp rise in rates, or a series of rises that come too early, could crush what Bank of Canada governor Stephen Poloz likes to call the tender "green shoots" of a recovering economy.

Fed as black hat

Especially in the current political climate, with the Trump administration ready to turn on the Fed, Yellen and her advisers know it would not be good for central banking to be portrayed as the black hatthat single-handedly crashed the recovery.

Even in her most recent speech,Yellen was careful to qualify her "would likely be appropriate" comments with the reservation that any move depended on conditions continuing"to evolve in line with our expectations."

Of course, the threats can only go so far. Last year,Yellenincreased her credibilityjust after the election when, after so many warnings,she finally fired a shot in the airwith the small December increase.

But if she thinks people aren't taking her warnings seriously, if the grumbling crowd begins to take a collective step forward, there is only one thing for Yellen to do:She must raise rates and show herself determined to keep raising.

And whether or not she pulls the trigger on Wednesday, it is only the conviction that she will actually do it when it is finally necessarythatgives the central bank its power.

Follow Don on Twitter @don_pittis

More analysis from Don Pittis