The Federal Reserve and the New Economic Normal

There is no doubt that the Federal Reserve is puzzled about the "lower than the Fed's comfort zone" inflation rate.  A recent talk by Governor Lael Brainard takes an interesting look at the latest monetary quandary to face the braintrust at the Fed.  In this posting, we'll start by looking at the Fed's "new normal" by defining the concept of a neutral (natural) interest rate and conclude by looking at the dangers to the economy that are posed by the Federal Reserve's policies during this long post-recessional period.

Governor Brainard opens by defining the key aspect of the Federal Reserve's new monetary policy normal:

"A key feature of the new normal is that the neutral interest rate - the level of the federal funds rate that is consistent with the economy growing close to its potential rate, full employment, and stable inflation--appears to be much lower than it was in the decades prior to the crisis."

Please note that, according to the Fed, the neutral interest rate can also be termed the natural interest rate or R* /R-star.

According to research by Kathryn Holston and Thomas Laubach at the Federal Reserve Bank of Sa Francisco, the natural rate of interest in the United States fell close to zero after the Great Crisis, significantly lower than it was in the decades prior to 2007 - 200.  As shown on this graph, r* or r star, the real short-term interest rate that pertains when the economy is at equilibrium (i.e. unemployment is at the natural state and inflation is at the two percent target) has dropped significantly in recent years as shown on this graph:

In fact, as shown on this graph, R-star has declined into negative territory according to the latest updated estimates of the baseline model designed by Thomas Laubach and John Williams:

The speaker notes that the low level of the neutral interest rate "limits the amount of space available for cutting the federal funds rate to offset adverse developments".  This means that there will likely be more frequent and longer periods when the Fed's interest rate policies are constrained by the lower bound (i.e. zero percent), where unemployment is at elevated levels and where inflation is below the Fed's targets.  This means that future lower bound episodes will be "more challenging in terms of output and employment losses", in other words, the Federal Reserve has now painted itself into a "monetary policy corner" from which there is no easy exit. 

Governor Brainard correctly observes that the Phillips curve which explains the relationship between unemployment and inflation looked like this in the 1960s:

...has slowly flattened as the decades have passed as shown here:

This means that, even in the essentially full employment environment that exists in the United States today, inflation stubbornly remains below the Fed's 2 percent target.  That said, Mr. Brainard is very concerned that the transition to a higher inflation target is "likely to be challenging and could heighten uncertainty" and that the public "may start to doubt that the central bank is still serious about its inflation target" if the Fed were to signal that its 2 percent target should be changed.  

One of the biggest problems with the current low neutral interest rate is related to cross-border spillovers where even small changes in interest rates on 10-year Treasuries leads to high changes in the value of the U.S. dollar.  Prior to the Great Crisis, a 25 basis point increase in the expected interest rate on the 10-year Treasure led to a one percentage point increase in the value of the dollar; now, that same 25 basis point increase leads to a three percentage point increase in the value of the dollar.  As well, cross-border spillovers are amplified on yields since the Great Recession resulted in a low neutral rate environment; for example, news from the European Central Bank that leads to a 10 basis point decrease in Germany's 10-year term premium is associated with a roughly 5 basis point decrease in the U.S. 10-year term premium.  These spillover effects were much smaller prior to the Great Recession.

One of the most telling parts of Governor Brainard's speech is found here (with all bolds being mine):

"Finally, a low neutral rate environment may also be associated with a heightened risk of asset price bubbles, which could exacerbate the tradeoff for monetary policy between achieving the traditional dual-mandate goals and preventing the kinds of imbalances that could contribute to financial instability. Standard asset-valuation models suggest that a persistently low neutral rate, depending on the factors driving it, could lead to higher ratios of asset prices to underlying income flows--for example, higher ratios of prices to earnings for stocks or higher prices of buildings relative to rents. If asset markets were highly efficient and participants had excellent foresight, this would not necessarily lead to imbalances. However, to the extent that financial markets extrapolate price movements, markets may not transition smoothly to asset valuations that reflect underlying fundamentals but may instead evidence periods of overshooting.  Such forces may have played a role in both the stock market boom that ended in the bust of 2001 and the house price bubble that burst in 2007-09.

The risks of such financial imbalances may be greater in the context of the kind of explicit inflation target overshooting policies proposed in the paper. Again, if market participants were perfectly rational, overshooting policies would not likely pose financial stability risks. But the combination of low interest rates and low unemployment that would prevail during the inflation overshooting period could well spark capital markets to overextend, leading to financial imbalances."

Basically, Governor Brainard is clearly (well, as clearly as any central banker ever is) telling us that the "monetary medicine" that has been used by the Federal Reserve and the world's other influential central banks could already be creating the next Great Recession, thanks to a low neutral interest rate, below target inflation and the Fed's seeming inability to see that its policies have created fiscal imbalances that could burst as was the case in 2001 and 2007 to 2009.  The bursting of this latest asset bubble will leave both equity and bond investors holding assets that are worth a fraction of what they paid for them.

The Federal Reserve's "new normal" could prove to be painful when it "unwinds", largely because the Fed has adopted policies that have proven to be ineffective over the past two decades in one of the world's other large economies, Japan.