The Fed's Other Debate
Low inflation readings this year have sparked a debate among Federal Reserve policy makers about just how useful the Phillips curve is to monetary policy.
But the lack of inflation in the economy even with the unemployment rate below 4.5 percent suggests the Phillips curve theory, based on the assumption that there's an inverse relationship between unemployment and inflation, is either not a good framework for understanding inflation dynamics or that estimates of the unemployment rate at which inflation should accelerate are too high. This is no small matter, because the Fed maintains a Phillips curve framework in determining the expected path of monetary policy.
But there's also a different debate raging among policy makers, one that deals with another variable in the Fed’s reaction function -- the neutral rate of interest. Fed officials describe the level of accommodation the central bank delivers in terms of the neutral rate. Chair Janet Yellen said in her recent congressional testimony:
The Committee continues to expect that the evolution of the economy will warrant gradual increases in the federal funds rate over time to achieve and maintain maximum employment and stable prices. That expectation is based on our view that the federal funds rate remains somewhat below its neutral level--that is, the level of the federal funds rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel.
Like the natural rate of unemployment, the neutral rate is an unobserved variable. This, of course, complicates monetary policy. How do you use a variable you can’t observe as a guide to setting interest rates? The Fed compensates by relying on estimates of the neutral rate such as those developed by a team led by San Francisco Federal Reserve President John Williams.
Where is the level of interest rates relative to the neutral rate currently? Back to Yellen:
Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. But because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal.
The neutral rate is quite low owing to the lingering damage to financial markets during the recession. Thus, actual policy now may not be very accommodative. Still -- and this is important -- Yellen anticipates that as the expansion continues, the neutral rate will drift back up to its longer-term levels. In other words, additional rate hikes will be necessary over the medium term to keep inflation in check. Consequently, the median rate projection for the end of 2019 is 2.9 percent, close to the Fed’s longer-run projection of 3 percent.
This issue, the likely path of the neutral rate, appears to be a growing source of contention among policy makers. In a recent speech, Fed Governor Lael Brainard said:
In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance. I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target.
This is very dovish. Combine a zero percent real rate with a 2 percent inflation target and you get a 2 percent nominal neutral rate over the medium term. Contrast that with Yellen, who believes that policy is currently close to neutral in the near term, but not over the medium term.
Yellen is the relative hawk now. She thinks the Fed has considerable room to maneuver over the next couple of years. Brainard sees much less room to maneuver. Her view suggests the Fed is not just near its terminal point for this cycle for the near term, but over the next couple of years as well. By this logic, then, the Fed is much closer to the end than the beginning.
This is something to watch. For now, I tend to see low longer term rates coupled with a flat yield curve as consistent with Brainard’s view, one in which the Fed reaches the terminal point by the end of 2018 (or somewhat before) under current projections. That means that in the near term, Fed hawks can continue to talk tough, but over the medium term the doves will ascend.
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