Goldman: The Fed Might Have a New, Big Idea

The natural rate of interest has been lower than previously thought.

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Leonardo DiCaprio as "Cobb" in a scene from the movie "Inception."

Photographer: Stephen Vaughan/Warner Bros. via Bloomberg

What is the most resilient parasite? Bacteria? A virus? An intestinal worm? An idea. Resilient... highly contagious. Once an idea has taken hold of the brain it's almost impossible to eradicate.

- Dominick Cobb, Inception

The Death Star is a fictional space station popularized by the Star Wars franchise.

The r-star (r*) is the natural rate of interest that sometimes crops up in economics texts.

It also might be the Federal Reserve's newest, biggest idea, according to strategists at the Goldman Sachs Group Inc.

The notion that the natural or neutral rate of interest has been stuck at ultra-low levels might help the U.S. central bank square a dilemma between hiking interest rates and strengthening the U.S. dollar, they said. 

"For the FOMC, this is a genuine conundrum, because it means that too hawkish a message could send the Dollar sky-rocketing, a deflationary shock that would also weigh on growth, thereby – in a way – undermining the very rationale for shifting hawkish in the first place," write Goldman strategists led by Robin Brooks. "To deal with this conundrum, the framework that many at the Fed seem to be converging around is that 'r-star' is low, so that the degree of monetary policy accommodation is only moderate, despite policy rates being so low." Such a stance could allow the central bank to justify keeping benchmark interest rates lower for longer.

While the strategists don't judge the notion on its merits, they do compare it to some previous big ideas that have been discussed at the central bank in recent years. Among these is the concept that the effects of the U.S. housing crisis would not be material – a theme that dominated in the two years before the 2008 financial crisis (and shown in the pink line below). That idea soon gave rise to concerns that the bursting of the housing bubble would have a negative impact on the U.S. economy (shown in blue).

Subsequently, policymakers' collective imaginations were captured by the notion that quantitative easing would prove positive for economic growth (in red), while the notion that forward guidance (in yellow) is a useful policy tool soon gained in popularity.

Source: Goldman Sachs

Goldman's team derived these charts from scanning mentions of each subject in the Fed minutes, taking care to ensure that each occasion was indicative of a forward-looking view rather than an update on current conditions. The economists acknowledge that this analysis produces something of a lagging indicator, as topics that appear in the minutes have typically been broached in speeches by individual monetary policymakers beforehand.

But – just as Leonardo DiCaprio's character in Inception alluded to  it'll take a lot of evidence for a data-dependent Fed to shake off the idea of an ultra-low neutral rate in favor of a more dominant intellectual narrative, according to Brooks.

"What lessons do we learn? Fed consensus views take a while to form, can stick around for years and, ultimately, are data-dependent. For the current debate around 'r-star,' we take away the following," he writes. "First, as Exhibit 2 shows, it’s early days, with lots of potential for this debate to grow into a fully-fledged policy discussion. Second, only a meaningful rise in inflation will put this idea on the back-burner, i.e., a turn in the data against this idea."

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