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.

How the Federal Reserve Painted Itself Into A Corner

Recent musings by John C. Williams, President at the San Francisco Federal Reserve Bank, look at the rather arcane concept of r* (r-star) or the natural interest rate.  The natural interest rate is defined as the short-term real rate of interest that balances monetary policy so that it is neither accommodative nor contractionary in terms of growth and inflation.  In other words, this abstract concept is extremely important to central bankers because it keeps the economy in balance, preventing it from both overheating or underperforming.  According to his fellow economists at the Richmond Fed, the natural rate of interest is "a key concept in monetary economics because it allows economists to assess the stance of monetary policy".  While that all sounds very clear cut, in fact, it is not.  The economists at the Richmond Federal Reserve Bank note that the natural interest rate cannot be observed, it must be calculated using identifying assumptions.  Before we look at John Williams' comments, let's look at a bit of background information about the natural interest rate, how it is calculated, how it has changed over time and how accurate the calculations are.

The aforementioned paper by Lubik and Matthes at the Richmond Federal Reserve Bank goes on to compare two methods of calculating r-star.  The first method, the Laibach-Williams method, was developed by two Federal Reserve economists in 2003 using a:

 "...state space model to calculate the fundamentally unobservable natural rate from actual data by specifying simple theoretical relationship that links interest rates to measure of economic activity."  

The authors go on to state that:

"This relationship has an economic foundation in a traditional Keynesian model, where movements in the real interest rate affect consumption and investment decisions. For example, an increase in the real rate due to a hike in the federal funds rate would, when prices are sticky, reduce consumption and investment. A similar relationship can be derived from a more modern forward-looking framework where real rate movements affect intertemporal household decisions on savings and portfolio allocation."

Here's a graphic showing how the natural rate of interest has changed over time according to the Laubach-Williams method:

It is interesting to note that this method shows that the natural rate of interest has been negative since 2011.  The Laubach-Williams model shows that the current Federal Reserve monetary policy is not tight enough, that economic output is running above its potential and that any inflationary pressures could be controlled by raising the federal funds rate.

In the second method, the time-varying parameter vector autoregressive or TVP-VAR model, the evolution of economic variables are examined over a period of time.  This results in a curve as such (shown in black as compared to the Laubach-Williams curve in red):

Notice the dashed lines?  These are the 90 percent confidence lines.  In other words, the brilliant minds at the Federal Reserve are only certain of the accuracy of their estimate of the natural interest rate to within two percentage points above and below their calculated value which, since the Great Recession, has been around zero (i.e. the margin of error is about where the level of the natural interest rate has been since the 1990s!).  For such a key central bank concept, their margin of error is rather appalling.  If you are interested in reading additional material about what is wrong with the very concept of natural interest rates, here is an article on Mises that you may find useful.

Now, that we have that background, let's go back to John Williams' musings.  In his Economic Letter, he includes the following diagram showing how natural interest rates have declined for all advanced economies:

He suggests that the drop in the natural interest rate was precipitated by several factors:

1.) the global supply and demand for funds including shifting demographics (i.e. aging populations looking for safe assets)

2.) slower trend productivity and economic growth

3.) a global savings glut

4.) emerging markets seeking massive reserves of safe assets

He suggests that interest rates are going to stay lower than they have in the past by at least a percentage point or more even when the economy is performing at full strength and central bank monetary policy is neutral (i.e. not trying to stimulate or slow down the economy).

Here is the key paragraph from his Letter:

"The critical implication of a lower natural rate of interest is that conventional monetary policy has less room to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. This will necessitate a greater reliance on unconventional tools like central bank balance sheets, forward guidance, and potentially even negative policy rates. In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher.  We have already gotten a first taste of the effects of a low r-star, with uncomfortably low inflation and growth despite very low interest rates. Unfortunately, if the status quo endures, the future is likely to hold more of the same—with the possibility of even more severe challenges to maintaining price and economic stability." (my bold)

While the very concept of the natural interest rate may seem arcane to the vast majority of us, to central bankers, it is the key to their future monetary policies and how they will control the economy in a future economic slowdown, a problem that may lie just around the corner.  

Let's close this posting with a quick quote that looks at one of President Williams' solutions to the problem of a low r-star environment:

"...the most direct attack on low r-star would be for central banks to pursue a somewhat higher inflation target. This would imply a higher average level of interest rates and thereby give monetary policy more room to maneuver. The logic of this approach argues that a 1 percentage point increase in the inflation target would offset the deleterious effects of an equal-sized decline in r-star." (my bold)

America's central bank, which has set a firmly entrenched two percent inflation target as a key part of its two part mandate, is now admitting that perhaps they have erred and need to allow inflation to rise by an additional 50 percent so that they have room to manoeuvre during the next recession.  It's an interesting and rather desperate turn of events when a central bank has painted itself into a monetary policy corner by keeping interest rates at the zero lower bound for too long, isn't it?  Ah, but you can always blame baby boomers, a global savings glut and emerging markets for your problems, can't you?