Imagine Fed Governor Rip van Winkle waking from a 10-year nap to find that trend inflation is only a bit shy of the 2% target, the unemployment rate is close to its long-run steady state, and the Fed’s balance sheet is five times larger than when he fell asleep. As we wrote two years ago, you could forgive him for expecting the federal funds rate to be closer to 4% than ½%. And, you would understand his astonishment when he learns that financial market expectations of policy tightening have collapsed amid continued economic expansion (see chart).
Federal Funds Futures Implied Rate, January 2017 contract
So, why are both the current policy rate and expectations of the future rate so low? There are four powerful reasons. First, both investors and policymakers have lowered their estimates of the steady-state (or “natural”) real interest rate. That means that Fed policy today is less accommodative than Governor Rip’s 10-year-old perspective leads him to think. Second, Rip is surely startled to learn that, even with a tightening labor market and policy rates close to zero, market-based long-run inflation expectations have declined. Third, it seems unlikely that Rip would be thinking much about the policy asymmetry that occurs when the nominal interest rate is near the effective lower bound. That is, as post-crisis experience suggests, with policy rates near (or even below) zero, it is much easier for central banks to tighten when prices rise too quickly than it is to ease should prices start to fall. Fourth, the economy’s productive capacity may be endogenous: that is, it may be possible for trend growth to be higher than recent experience suggests.
These considerations all support the FOMC’s continued restraint. That said, it appears that markets have scaled back the projected path of policy rates further than policymakers have. On balance, our best guess is that the FOMC will tighten a bit more over time than markets expect, but we say so with limited conviction, not least because we have thought so before.
The natural rate of interest. From our perspective, the sustained decline of the natural rate of interest is the leading factor behind the fall in policy rate expectations. It is important to keep in mind that the natural rate—the rate of interest consistent with the economy operating over the long run with normal use of capital, labor and other resources—is determined by the structure of the economy. The fact that long-term real interest rates around the world are unusually low today is not because central banks are keeping them there, but because people expect economic growth to remain unusually slow, limiting the projected returns on investment. Put differently, don’t blame the central banks for persistently low interest rates—they are a symptom of weak economic performance.
The chart below shows a model-based estimate of the natural rate (labeled R*) together with a market-based estimate based on the expected future real rate of interest (in this case, the nine-year ahead one-year forward rate of interest calculated from the U.S. TIPS yield curve). The model estimate shows a decline from roughly 3 percent in the late 1990s to less than 0.25 percent today. While these are the best estimates of R* that we know of, it is important to keep in mind that they come with substantial uncertainty. That said, market expectations for the distant forward real interest rate (red line in the chart) display a similar declining pattern.
Estimated Natural Rate of Interest and the Market-expected Distant Forward Real Interest Rate, 1985-3Q 2016
Like researchers and investors, FOMC members have been lowering their implicit estimate of the natural rate. We can see this by looking at the quarterly Summary of Economic Projections (see the latest version from June 2016 in Figure 2 here), which includes a “longer run” level of the nominal federal funds rate that FOMC members associate with the economy’s steady state. Subtracting 2 percent from those projections—to adjust for the FOMC’s inflation target—the following chart shows that the entire range of FOMC natural rate projections has shifted lower over the four years for which these projections have been published. And, the median has declined from 2.25% to 1.00%. If we also adjust for the roughly ½-percentage-point historical excess of CPI inflation over the Fed’s targeted inflation measure (which is based on the price index of personal consumption expenditures), the median FOMC implicit estimate of the natural rate is already down to about ½%, a tad below the market measure in the chart above.
FOMC implicit longer-run real interest rate projections (range and median), 2012-June 2016
Long-term inflation expectations. The decline in market-based long-run inflation expectations provides the second argument for policy caution. The next chart shows five-year forward five-year inflation expectations based on the difference between the U.S. nominal and TIPS yield curves (and adjusted for the average difference between the CPI and the PCE inflation rates). While this market-based measure can move because of changes in risk and/or liquidity premia, the roughly one-percentage-point decline since the start of 2014 is large enough to signal a decline in inflation expectations. Consequently, policymakers are and should be puzzled. Why, if their policy stance is so stimulative, have long-term inflation expectations slipped so far below the FOMC’s 2 percent target?
Adjusted, market-based five-year forward five-year inflation expectations
Policy asymmetry. The challenges facing central banks in Europe and Japan today are a stark warning to U.S. policymakers: it is easier to manage a mild inflation overshoot than to battle “low-flation” (let alone deflation). Following its July meeting, the FOMC stated that “near-term risks to the economic outlook have diminished.” Yet, with some economies still facing deflation, the asymmetry of conventional interest rate policy, together with the uncertain impact of unconventional tools, provides a strong argument for waiting. As we have written before, this is likely a key justification for the Fed’s risk-management approach to policy. We suspect a number of FOMC members would welcome a temporary period of inflation somewhat above 2 percent after so many years of sub-target inflation.
Endogenous supply and hysteresis. Financial crises are often followed by persistently weak economic growth. The usual response to this has been gradually to reduce estimates of potential (sustainable) growth, implicitly blaming the decline on mysterious and unobservable technological factors that are driving productivity growth rates down (see our earlier post here). But there is another possibility. Known as hysteresis, the idea is that deep recessions arising from shortfalls in aggregate demand cause weakness in the growth of productive capacity or potential output. Economists have suggested a range of reasons why, in the aftermath of a crisis, a more rapid pickup in aggregate demand could lead to a faster expansion in potential output. In the current episode, for example, strong demand could reverse some of the post-crisis decline in prime-working-age labor force participation. It also could foster new business formation, investment, R&D, and the adoption of new technologies that were delayed by post-crisis deleveraging or by policy constraints, such as the effective lower bound on monetary policy (see, for example, here and here).
The combination of a dramatically lower equilibrium real rate, falling inflation expectations, policy asymmetry, and the possibility of reversing hysteresis provide a compelling justification for U.S. monetary policymakers to take it slow—much slower than would have been justified in objectively similar circumstances a decade ago.
But precisely how slow? That is the FOMC’s ongoing challenge. Our sense is that, even if increasingly scarce labor finally leads to an investment pickup (as we and many others hope), aggregate demand will likely rise faster than capacity. And, while interest rate increases probably will remain modest compared to what they would have been a decade ago, a gentle rise of inflation will lead them to be a bit faster than markets currently anticipate. Even so, patience still appears to be a policy virtue.