Looking back at “Trend of Interest Rates”, posted on May 26, 2016

If you have yet to read the post, you can find it here.  Towards the end of the post you will find the following paragraph:

In summary, financing costs, as represented by the rate imposed by the US central bank, rates used in bank lending and the rate acceptable to debtors, should remain relatively low.  It is no longer necessary to levy large rates to affect economic activity.  If the effective Federal Funds Rate has been near zero since 2009 and the velocity of money has not recovered, it is easy to posit that small increments in interest rates should impact economic activity more than adequately.

This week, the Federal Reserve announced its intention to maintain the target range for the fed funds rate at 0.25% to 0.5%.  In making the announcement, Janet Yellen expressed the following:

We continue to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain our objectives. That’s based on our view that the neutral nominal federal funds rate–that is, the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel–is currently quite low by historical standards. With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives. But since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.

And in response to Reuters’ Howard Schneider’s question:

Howard – I was wondering if you could comment a little bit on the apparent tension between the steady drift down in the long run rate, and the steady drift down in some of the projections and the seeming march towards a rate hike. If the neutral rate is coming down over time and continues coming down and you’re eating up accommodation that way anyway, why not wait for the dust to settle on that before moving right so?

Yellen –  So, it is true that our estimates of the neutral rate are coming down and that’s what’s largely responsible for that shift. At the same time, we generally agree that the stance of monetary policy is somewhat accommodative. So, 180,000 jobs a month is a faster pace of employment growth and is sustainable in the longer run. Now, we have seen people come into the labor force and maybe more than would be expected, which is why the unemployment rate hasn’t fallen. But that’s probably not something that is possible without the economy overheating on an indefinite basis. So, policy needs to be forward-looking. We don’t want the economy to overheat and significantly overshoot our 2 percent inflation objective. That’s one risk that we need to address. And I think we generally agree that some gradual increases to remove that accommodation will be appropriate if we stay on this course, but as I emphasized, it’s not that much accommodation and the economy has shown evidence that there are more people who are being attracted back into the labor force. So in that sense, I would characterize it as we found the economy has a bit more running room, nevertheless, we don’t – 8 – want the economy to overheat. And if things continue on the current course, I think that some gradual increases will be appropriate. And mainly, what we discussed today were issues affecting the timing of such increases.

Then, Craig Torres of Bloomberg asked the following:

Mr. Torres – Madam Chair, Craig Torres from Bloomberg. What observable data would convince you and the committee that this neutral federal funds rate is starting to move up? There’s a popular piece of research by one of your colleagues that suggests that it’s at zero right now. And second, I’m struck by your opening remarks that the economy isn’t overheating? But does that mean the committee sees this global reach for yield going on right now as is very low cost to its policy?

Yellen – (lengthy response, cut out what wasn’t necessary for today’s post) So, in most advanced nations now, we have highly accommodative policies. And they seem to be necessary for countries to be able to achieve their inflation and employment objectives. And that’s characteristic of an environment in which the neutral rate– interest rates both here and in advanced countries around the globe appeared to be very low.   And that is an environment that, if we do have to live with that for a long time, we have to be aware that it does give rise to a reach for yield as individuals and investors seek to, perhaps, take on risk or lengthen maturities to seek higher yields. 

The topic of “neutral rates” is one of the most important points of any recent Fed decisions.  Many analysts fear inflation could get out of hand, basing their arguments on historical examples of hyperinflation around the world and in recent history.  Some of my previous posts make reference to my personal belief that we should lower our rate expectations, but I neglected to use proper terminology by omitting the words “Neutral Rate”.

More responses from Yellen:

On the other hand, inflation is running below our 2 percent objective, and it’s also important that we make sure we get back to 2 percent, and I have routinely indicated a number measures of inflation expectations that are running at the low ends of their historical range, and we’re watching that as well. And there would also be risks from not seeing inflation move back to our 2 percent objective. And exactly how to balance these two risks, which is more serious– which is a more serious risk, can affect one’s judgment about the appropriate timing, and we’re all struggling to understand the magnitude and nature of those two risks.


So, the projections, I agree the projections for growth are slow. We have further written down or estimate of the longer run normal growth rate. And with that reflects is in assessment that productivity growth is likely to remain low for an extended time although, it doesn’t bother and expectation that it will pick up from the miserable half percent pace per year that we have seen over the last five years. Now, why we would never– and slow growth is a factor. Slow productivity growth is a factor that influences the longer run normal level of interest rates and writing down the likely pace of productivity growth is one factor that is responsible for the downward shift in the path that you see for the federal funds rate. That’s an important reason for revising down the neutral rate. But now, let’s go to your– the part of your question about inflation. In spite of having such slow growth disappointing productivity growth, we have a labor market that last year generated in average of about 230,000 jobs a month. And so far this year has been generating about 180,000 jobs a month. And that is a very solid pace of job growth and a pace that likely is not sustainable in the longer run. Although, we’ve been pleased to see people come back in the labor market. So, it certainly is sustainable for some further amount of time. But, I think what ultimately drives inflation, both wage and price growth is that tightness in the labor market and pressure on resource utilization. And, the sad fact is that we are getting that healthy pace of job market growth with very slow growth in output. So, this is– I don’t think it bears on the inflation outlook, it has prompted a downward shift in the projected path for the neutral and actual federal funds rate. But it is a huge concern because slow – 20 – productivity growth ultimately means slow growth in living standards. And that’s a big concern that policymakers should be focused on.

So, I think the notion that monetary policy operates with long and variable lags, that statement is due to Milton Friedman and it is one of the essential things to understand about monetary policy and it is not fundamentally changed at all. And that is why I believe we have to be forward looking and I’m not in favor of the whites of their eyes rights sort – 22 – of approach. We need to operate based on forecasts. But the global economy and the US economy have changed a lot. History doesn’t always exactly replay itself. Many of the– those of us sitting around the table, we learned the lesson that if policy is not forward looking, that inflation can pick up to highly undesirable levels that inflation expectations can be dislodged upward and the consequence of that can be that endemically higher inflation takes place which it is very costly to reduce. And absolutely, none of us want to relive an episode like that. And so I believe and my colleagues that it is important to be forward looking. We’re going to make that mistake again. But the structure of the economy changes, things do change. The nature of the inflation process is changed I think significantly since the bad days of the ’70s when the Fed had to face this chronic high inflation problem. We’ve seen inflation respond less to the economy, to movements in the unemployment rate that sometimes said the Phillips curve has become flatter. So we’ve seen less of a response, that’s something we need to factor into our decision making. Inflation expectations appear to be better anchored, and perhaps that’s been a result of a long period of low and stable inflation. That’s an asset, it’s something we didn’t have in the 1970s. And in addition, we have to be attentive to the fact there we’ve now had a long period in which inflation is actually undershooting our 2 percent objective. And we see some signs that what I– I would conclude inflation expectations are reasonably well-anchored at 2 percent. But we are seeing signs suggesting possible slippage there and we’re long way from being– facing the problems that Japan faces. But there always a– should be a reminder to us that we also would not want to find ourselves in a period where inflation is chronically running below our objective. Inflation expectations are slipping and with a low neutral rate that becomes more important. So, things are changed, but principle of forward looking absolutely hold

Yellen is openly admitting to the fact that advanced economies are seeing much lower neutral rates than has been modeled by them, or anyone else for that matter.  This is why they seem behind the curve, but so are the majority of economists around the world.  Easy monetary policy has not given rise to the growth or inflation that was modeled by using data from previous periods, such as the 70’s.  They forgot to include in their models a factor that represented lower costs of managing risk at the most basic level, as presented in the post from May 26th.  Governments in advanced economies have been responsible as well, for implying that they are the backstop to risk and failing to prosecute bad actors that elevate risk in markets.

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