Here's Why Fed Doves and Hawks Could Both Be Right
When Federal Reserve Board officials meet at the Jackson Hole summit on Friday, they will grapple with a question that will influence both their near-term policy stance and their longer-term monetary framework: what's the outlook for the underlying natural interest rate of the economy?
The natural interest rate, sometimes known as its neutral rate, is the inflation-adjusted level that's consistent with the U.S. economy expanding at its full potential without overheating — in other words, it assumes that the Fed is fulfilling both the full employment and stable inflation components of its mandate.
The inferred neutral rate fluctuates in response to both cyclical and structural changes in the economy, and holds the key to whether the Fed's policy stance is accommodative, restrictive, or balanced. If policy rates are higher than the economy's underlying rate without the dual mandate being achieved, it would needlessly choke off growth; on the other hand, holding rates too low when the economy's running at full capacity raises overheating risks.
Fed officials have downgraded their estimates of the neutral rate in recent years, from 2 percent in the pre-crisis era to around zero currently, citing the effects of the global crisis and structural shifts in the U.S. economy.
Even though Federal Open Market Committee (FOMC) participants have downgraded their projections this year for the Fed-funds rate in the long run, as the dot plot below shows they were more hawkish at the June meeting than current market-implied odds. Their forecasts imply an uptick in the economy's neutral rate in the coming years as the effects of the crisis diminish. Fed officials' rate projections suggest the real natural rate for the U.S. economy will rise to between 1 percent and 1.25 percent, according to analysts at Deutsche Bank AG.
These FOMC projections are contentious. San Francisco Fed President John Williams this month urged a dramatic re-think of how central banks conduct monetary policy. He suggested the Fed's inflation-targeting regime could eventually make way for a nominal-GDP target, citing the possibility that the U.S. is in the throes of secular stagnation, which means the neutral rate will remain stuck at historically low — and possibly negative — levels.
In a research report published on Tuesday, the Deutsche Bank economists led by Peter Hooper provide ammunition for both doves — those who reckon low natural rates justify keeping the Fed's policy rate lower for longer — and hawks, who reckon the Fed should press ahead with its projections for rate hikes in the coming years. They reckon the neutral rate for the U.S. is significantly below what Fed expects in the coming years — but, even so, they say monetary policy officials' projections for rate hikes are consistent with models the Fed uses.
Using the benchmark 2003 Laubach-Williams (L-W) model to derive the future path of the neutral Fed funds rates, the Deutsche analysts reckon the neutral rate is unlikely to rise significantly in the years through 2019, if U.S. real GDP growth averages 2 percent, as the Fed expects. This means, contrary to the central bankers' forecasts and commentary, a rising natural interest rate is unlikely to be the driver for near-term rate increases. If U.S. economic growth undershoots, slowing to below 1.5 percent, the real neutral rate would remain stuck at zero, the analysts calculate.
By the end of 2020, the projected range for the real natural rate is between 0.5 percent and 0.85 percent, well below the Fed's long-run estimate of a neutral rate of at least 1 percent.
However, despite these dovish projections, Deutsche's model finds that the Fed's projections for the nominal Fed funds rate through 2018 are reasonable, citing, in part, the fact that the current Fed funds rate is lower than that implied by the Taylor rule, which attempts to define what the trade-off between inflation and the unemployment rate entails for the appropriate level of policy interest rates.
The analysts explain the divergence between their projection that the natural rate of interest will remain at stubborn lows and their view that the Fed can justify rate hikes in the coming years. "This is due to the facts that (1) the current Fed funds rate is well below levels consistent with Taylor rule projections even with the low neutral rate estimated by L-W and (2) current Fed projections already have very dovish built-in assumptions about the level of the neutral rate."
They conclude: "The bottom line importance of our findings is that they help to explain why the Fed can feel comfortable about a historically very gradual pace of rate hikes going forward--albeit faster than the market has been projecting in the years just ahead."