Guest post by Norman Mogil
When the Federal Reserve's Open Market Committee (FOMC) meets this week, there will be pressure from various quarters to raise the federal funds rate. Jamie Dimon, chairman of JP Morgan, has stated blankly “Let’s just raise rates." Furthermore, he has said a quarter point is just a “drop in the bucket." We know where the big money banks stand on the issue. They need higher rates to achieve better profit margins. But even from other financial quarters, there are calls for the Fed to stop speaking and start acting. Many point to that fact that the labor markets have recovered very well from the 2008 crash and that the economy is hovering around full employment. Although the Fed's inflation target has not yet been reached, there are many who warn that the real risk now lies in getting behind the curve. Once the inflation genie is out of the bottle, they argue, it will be too hard or, at least painful, to put back.
So, why is it that the Fed is so reticent to start a real move towards ‘normalizing’ credit conditions?
The Level of Interest Rates
In a speech last week, Fed Governor Lael Brainard offered an insight into this question. The clue to her thinking lies in the analysis of the "neutral rate of interest." This rate is defined as the "level that is consistent with output growing close to its potential and with full employment and stable inflation". In other words, it is an ideal condition when the economy is using all its resources to the fullest and inflation remains constant. If the fed funds rate is below the neutral rate, then monetary policy is promoting expansion; a fed funds rate above the neutral rate implies a tightening of monetary conditions.
But here is the rub. The “neutral rate” cannot be observed. We have to back out the number by observing the behavior of the major components of the economy; we need to look at output and employment as it is and then judge whether what we observe are, in fact, the conditions that give rise to the neutral rate. It is a judgment call and, with all such calls, one that can be second-guessed.
Governor Brainard argues, on two related grounds, for waiting longer before raising the federal funds rate: 1) that the current fed funds rate is consistent with the current neutral rate, and 2) the neutral rate today is much lower than the rate in previous decades. In other words, this time, it is different.
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It is this second point that bears scrutiny. There has been a downward shift in the neutral rate. Hence, we are in what is now referred to as the “new normal”. There is a lot to be said in support of this view. During the Great Recession, starting in 2008, nominal interest rates have been zero in the US (and negative in the EU and Japan). All the while, growth has been subdued (less than 2 percent) and inflation very stable (about 1.5 percent). Put differently, the US economy continues to expand modestly with the nominal rate at zero and the real rate negative. This has not happened anytime in the post-war era.
The Pace of Future Rate Increases
Turning to the future, Brainard points out that the Blue Chip consensus anticipates that the longer-run federal funds rate will be 1.1 percent over the next decade. This is about 1 percent lower than the pre-crisis average. It now appears that the FOMC has adopted a similar outlook. In January 2012, the Fed projected a long run average federal funds rate of 2.25 percent. Now, its most recent projection is for a rate of 1.5 percent—a significant 75 basis points (bps) downward revision. The Fed is recognizing that the “new normal“ features a much lower funds rate, a much lower neutral rate and hence there is no urgency to raise rates.
Given this outlook, what can be inferred about the pace of future rate increases? After all, if the new normal features a lower neutral rate and accompanying slower growth and subdued inflation, then what will be the path for future rate changes in pursuit of ‘normalization’?
Brainard lays out a case for a very slow pace, with the following:
But seven years into the expansion and with little sign of a significant acceleration in activity, the low neutral rate looks likely to persist. Indeed, developments over the past year confirm that the underlying causes will be with us for some time. Foreign consumption and investment are weak, while foreign demand for savings is high, along with an elevated demand for safe assets. Productivity growth, which increased at an average annual rate of nearly 2-1/2 percent from 1950 to 2000, has increased only 1/2 percent on average over the past five years, and demographics also suggest a persistent slowing of the labor force.
This is a long list of what ails economies everywhere. Simply put, all the weak conditions that are present today are expected to continue in the future. If the current conditions justify near zero-bound interest rates, then we can expect near zero-bound rates for a considerable time. At best, those who want the Fed to move faster will have to be content with ‘baby steps’.