The market recognizes that the indication by the FOMC at the end of last
year that four rates hikes in 2016 may be appropriate was far from the
mark. At the same time, investors are coming around to the prospects
that the Fed is not one and done either.
A key issue for investors and policymakers is what is the terminal rate for
Fed funds. This terminal rate is what economists call the natural or
neutral interest rate. It is the rate that is consistent with full employment
and capacity utilization and stable prices.
In June, the Fed’s dot-plot pointed to a long-term equilibrium rate
(natural or neutral rate) of 3%. It has been steadily revised lower, which
is one of the most important signals from the Federal Reserve.
letter address this issue. The analysis is interested in what
economists call r* (r-star). It is the natural rate adjusted for inflation or real rate. The current
estimate is that it is near zero. It is expected to rise gradually.
Historically, there is a strong statistical relationship between the growth of
potential GDP and the real natural rate,
of r*. A 2% growth rate of potential GDP translates to about a 1%
r*.
R* closely tracks the four-quarter growth rate of potential GDP as
calculated by the Congressional Budget Office. Those estimates are
projected 10-years out. Using the CBO series, Kevin Lansing at the San
Fran Fed calculates that, given the historical
relationship, the CBO estimates point to a very gradual increase in the r* from
near zero now to 1% in 2026.
If inflation is near 2% and r* is near 1%,
then the long-term equilibrium rate for nominal Fed funds may be a
little below 3%. On one hand, that means that the FOMC may have
nearly completed its adjustment. Consider that at the start of 2012; the dot plot implied a long-term equilibrium rate of 4%.
When looking at the historical
performance, Lansing notes that r* is on
a downward slope, that predates the Great Financial Crisis. Real Fed
funds were below what was implied by r* between Q1 2001 and Q1
2006. Some argue that it was this easy policy that fueled the housing
market bubble. Others argue that the source of the bubble was not easy
monetary policy by lax lending standards.
In any event, the decline in potential GDP growth has direct implications
for r*. In 2006, the CBO estimated potential growth at 2.5%.
Now it is 2.0%. The decline in potential growth projections fuels the
secular stagnation debate. At the same time, the low levels
discussed here means that in future cyclical downturns, the lower bound (zero)
may be approached.
The Federal Reserve like the central banks in the UK, Australia, New
Zealand and Canada, appear not to have been persuaded the negative interest rates are appropriate for them.
Personnel may change, and this is not a
commitment, but there seems to a clear bias
against negative interest rates.
At the same time, as the Fed’s Fischer did earlier, officials are not
particularly critical of the negative rate regimes by the ECB, a few other
European countries, and Japan.
Nor does the IMF seem particularly opposed. Some were critical that
last week, Yellen stuck to the current Fed playbook of asset purchases and forward guidance. She did concede that a
wider range of assets may be purchased.
Suggestions like boosting the inflation
target do not seem particularly helpful
at this stage. Changing the Fed’s target from inflation to nominal GDP
may be worth investigating, but it may require a change in the Fed’s charter.