Federal funds rate

Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

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The Fed's successful tightening

No one should be surprised that the Fed is tightening monetary policy and expects to tighten significantly further over coming years. Unemployment is less than 5 percent, consistent with normal use of resources. Inflation is approaching the FOMC’s 2 percent objective. And policy rates remain below what simple guides would suggest as normal.

A key issue facing policymakers today is whether the Fed’s new operational framework is working effectively to tighten financial conditions without creating unnecessary volatility. While the FOMC’s actions are occurring in a familiar macroeconomic environment, the legacy of the crisis makes raising rates anything but routine. The key difference is the size of the Fed’s balance sheet. Unlike past episodes, when commercial bank reserves were relatively scarce, today they are abundant.

This difference—reflecting a balance sheet that is over four times its pre-crisis level—creates technical challenges for the Fed. The traditional approach of using modest open-market operations (through repurchase agreements of a few billion dollars) to control the federal funds rate—became ineffective as reserves grew abundant. This meant developing an entirely new operational framework. The good news is that—up to now—the challenges of policy setting with abundant reserves have been very clearly met. While this may seem mundane, it is no small achievement. Much like plumbing, had the Fed’s new system failed, everyone would have noticed. At the same time, there are still challenges to face, so we’re not completely out of the woods....

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The FOMC's Prudent Caution

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.

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...

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How the Fed tightened

Back in August, we explained the mechanics of how the Fed can tighten policy in today’s world of abundant bank reserves. Now that the first policy tightening under the new framework is behind us, we can review how the Fed did it, if there were any surprises, and what trials still lie ahead.

So far, the new process has been extraordinarily smooth – a tribute to planning by the Federal Open Market Committee (FOMC) and to years of testing by the Market Desk of the Federal Reserve Bank of New York (FRBNY). But it’s still very early in the game, so uncertainties and challenges surely remain.

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What will the Fed use as its operating target?

In 2012, the Federal Reserve’s Open Market Committee (FOMC) clarified its long-run goals of price stability and maximum sustainable employment in a strategic statement that included for the first time a numerical inflation objective. While these ultimate objectives have evolved over the years, the FOMC’s operating instrument has been unchanged at least since 1981, when it began to target the federal funds rate -- the overnight interest rate on unsecured interbank loans. Since December 16, 2008, the target has been 0.00 to 0.25 percent, effectively at the zero lower bound for nominal interest rates. The history of the federal funds rate target is shown in the accompanying figure (and here). 

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