Fed Should Raise Rates Later and Faster, Hatzius and Harris Say

The Federal Reserve should delay its first increase in interest rates then raise them more sharply thereafter, according to research by a group of economists including Jan Hatzius of Goldman Sachs Group Inc. and Ethan Harris of Bank of America Corp.

The 80-page paper, for presentation at the U.S. Monetary Policy Forum in New York on Friday, argues that such a strategy is best given how difficult it is to determine the long-run equilibrium federal funds rate. In inflation-adjusted terms, that rate could be anywhere from a little over zero to 2 percent, though it is more likely in the higher end of that range than the lower, the article suggested, using data dating back to the 19th century.

Policy makers “may want to adopt a later but steeper path for normalizing the funds rate,” wrote Hatzius, Harris and fellow authors James Hamilton of the University of California at San Diego and Kenneth West of the University of Wisconsin.

Fed Presidents William C. Dudley of New York and Loretta Mester of Cleveland are scheduled to discuss the paper at the forum, which is sponsored by the University of Chicago’s Booth School of Business. Mester said on Thursday that she wants the option to be able to raise rates at the Fed’s meeting in June.

The central bank has held the benchmark fed funds rate near zero since December 2008.

Fed Forecasts

Most policy makers peg the long-run funds rate at 3.75 percent, according to estimates released by the central bank on Dec. 17. With a Fed inflation target of 2 percent, that would equate to a real equilibrium rate of 1.75 percent.

Investors in the futures markets are betting that the equilibrium rate is much lower, around a half percent, according to calculations by Bloomberg.

The paper’s authors said they were skeptical of the argument that the U.S. economy was stuck in a state of secular stagnation that would keep the real funds rate near zero for many years to come.

“We think the long-run equilibrium U.S. real interest rate remains significantly positive,” they wrote. “But we find little basis in the data for stating with confidence exactly what the value of the equilibrium real rate is going to be.”

Given the uncertainties, the Fed needs to be cautious in raising rates and should wait for more evidence from the economy and especially inflation that such increases are “clearly warranted,” Hatzius and his fellow authors wrote.

Simulations using the Fed’s own computer model suggest that delaying liftoff by six months would be an appropriate strategy to follow given the difficulties involved in discerning the equilibrium rate, according to the paper. The delayed start, though, would mean that rates ultimately would need to be raised faster and further than otherwise, the research found.

Hatzius is chief economist for Goldman Sachs in New York. Harris is co-head of global economics research at Bank of America Corp. in New York.

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