• Fed policy may not be that easy, accounting for lower rate
  • Massive uncertainty persists surrounding where neutral lies

Federal Reserve officials just aren’t sure how much stimulus their zero-interest-rate policy is providing.

At issue is the level of the so-called natural, neutral or equilibrium rate of interest, which is the borrowing cost -- adjusted for inflation -- that keeps the economy at full employment with stable prices.

Economists from the academic world and even within the central bank are vigorously airing differing views on where the rate lies in the aftermath of the worst recession since the Great Depression. The uncertainty is yet another reason for Fed officials to go slowly as they begin raising interest rates for the first time since 2006.

“The one thing you know is that you don’t know,” said James Hamilton, an economics professor at the University of California at San Diego, who co-authored a paper this year describing how Fed policy could handle such ambiguity. “People in the Federal Reserve and everywhere else are trying to figure out: What’s the permanent change, and what’s just the overhang from the episode we’ve been through?”

Easy or Tight

The natural rate is a theoretical concept that can only be estimated. It matters because where it lies in relationship to the Fed’s actual benchmark overnight federal funds rate determines how much support monetary policy is really giving the economy.

If the natural rate is well above the current near-zero rate, as Chair Janet Yellen and many of her colleagues suggest, then policy will still be accommodative well after the central bank begins to raise rates, encouraging further investment and hiring.

If the gap is smaller -- or if the natural rate has fallen so much that it’s at or under zero, as some suggest -- the early stages of tightening could restrain the U.S. economy more than Fed officials expect.

“There’s a lot of uncertainty about what the appropriate level is,” said Laura Rosner, U.S. economist at BNP Paribas in New York, and a former New York Fed researcher. Such discord “is going to heighten the disagreement about what to do with rates.”

The policy-setting Federal Open Market Committee is expected to hold the fed funds rate near zero when it meets Oct. 27-28. Yellen and others have in recent weeks said they still view an increase as warranted this year provided their forecasts stay on track, focusing attention on the FOMC’s December meeting.

Where Fed officials think the neutral rate now lies will influence when they decide to start raising rates and how quickly the subsequent tightening cycle proceeds. Policy makers have repeatedly said they expect to move gradually.

‘Immensely Accommodative’

Yellen said at her post-FOMC press conference in Septemberthat policy is “immensely accommodative” and will remain easy even after rate increases commence.

In March, she signaled that the equilibrium rate was going up as economic headwinds faded, and therefore the Fed’s target rate would need to rise in tandem. 

The San Francisco Fed in recent weeks has issued research papers that offer different takeaways on the level of the neutral rate.

The bank’s President John Williams and co-author Thomas Laubach estimated in a newly revised study that the rate has fallen sharply since the recession began in December 2007 -- reaching minus 0.2 percent in the first half of 2015 -- and shows no sign of recovering toward its pre-recession level of 2 percent.

The paper emphasized that a lack of conviction “in turn creates uncertainty about the appropriate level of the short-term interest rate to achieve a certain stance of monetary policy.”

Their estimate of the neutral rate means that today’s near-zero policy rate is still very accommodative once it’s adjusted for inflation.

Go Slow

Even so, headwinds depressing the neutral rate argue for a “gradual pace of removing accommodation,” Williams said in an Oct. 19 interview on Bloomberg Television.

San Francisco Fed senior economist Vasco Cúrdia argued in a paper published earlier this month that the equilibrium rate may have dropped so much that “monetary conditions remain relatively tight despite the near-zero federal funds rate.”

Source: Vasco Cúrdia paper
Source: Vasco Cúrdia paper

Cúrdia examined the neutral rate in the short run, which is influenced by temporary shocks to the economy, while Williams focused on the rate’s long-run trend, affected by slow-moving changes in such things as productivity. Cúrdia pegs the current level at around minus 2.1 percent.

There’s also disagreement about how the Fed should respond to the uncertainty surrounding the level of the natural rate.

While Williams at the San Francisco Fed has said he favors raising the benchmark rate sooner rather than later and then going slowly, research published this year by the University of California’s Hamilton, Goldman Sachs’ Jan Hatzius, Bank of America’s Ethan Harris and University of Wisconsin’s Kenneth West advised the opposite.

Delay Liftoff

If policy makers are uncertain about the equilibrium interest rate, they should adopt “a later but steeper path for normalizing the funds rate,” the authors found in a paper revised in August.

Speaking at a Wall Street Journal event last month, New York Fed President William Dudley said that "monetary policy isn’t as easy as people think it is," or the economy would be growing faster. That argues for a gradual pace of tightening after liftoff, he said.

Going slowly will give the Fed time to figure out how the economy is reacting to higher borrowing costs, enabling policy makers to get a better handle on where the neutral rate lies.

As Williams and Laubach quoted the late economist John H. Williams in their new paper, “if the bank policy succeeds in stabilizing prices, the bank rate must have been brought in line with the natural rate, but if it does not, it must not have been.”

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