The Federal Reserve keeps baby-stepping toward a “normalization” of monetary policy. But just what is normal?
As seen in the Fed’s latest quarterly Summary of Economic Projections (SEP) compiled at its June 17-18 Federal Open Market Committee meeting, the definition keeps changing.
Fed officials’ estimates of the longer run funds rate, also known as the equilibrium or normal rate, have continually fallen during the last few years.
In January 2012 when the FOMC first began announcing funds rate projections, 16 of 17 participants put the longer run rate at 4% or higher, with six estimating it at 4.5%. Only one had it at 3.75% or lower.
In March, 10 of 16 participants thought it was 4% or higher, and thought it was as high as 4.5%. Two put it at 4.25%. Six said it was 3.75% or lower.
Now, in the latest SEP, only 5 of 17 think the longer run rate is 4% or higher, and 11 estimate it to be 3.75% or lower.
The downward revisions in the normal longer run funds rate have coincided with a downgrading of the economy’s longer run growth potential. FOMC’s participants now put it at 2.1% to 2.3%, down from 2.3% to 2.6% in January 2012 and even faster before then. The estimates are not directly comparable because the FOMC’s composition has changed, but the downshifts are arguably still significant for monetary policy.
The FOMC doesn’t set the actual funds rate solely on the basis of estimates of the equilibrium rate; a good deal of judgment is involved. But in presenting policy options to the Committee the Fed staff does rely heavily on Taylor-type rules in which the equilibrium rate is a key variable.
Fed Chair Janet Yellen has often spoken favorably of such rules, and has said the Fed needs to respond in a systematic or rule-based way to changes in the economy.
Moreover, the FOMC keeps saying that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
It may all sound very esoteric, but the lower the longer run rate is believed to be, the lower the actual funds rate theoretically needs to be. The level the funds rate is apt to attain over time could be lower than previously thought, because the FOMC has revised down the “normal” reference point.
The FOMC and Yellen are sending mixed messages. While phasing out the bond buying it has been doing to hold down long-term interest rates—now $35 billion per month, down from the original $85 billion—the FOMC continues to pledge that the funds rate will be kept near zero “for a considerable time” after quantitative easing ends and, again, be kept “below normal” thereafter.
While lowering the median longer run rate from 4% to 3.75% in June, assessments of the “appropriate” funds rate over the next three years—the “dots”—are actually somewhat higher than they were in March. The median funds rate assessment for the end of 2015 rose from 1% to 1.13% and from 2.25% to 2.5% by the end of 2016. Remember those assessments include non-voting, typically more hawkish Fed presidents.
Yellen was even more careful to emphasize policy uncertainty than in her first post-FOMC press conference. “It is important for market participants to recognize that there is uncertainty about what the path of interest rates, short-term rates, will be, and that’s necessary because there’s uncertainty about what the path of the economy will be,” she told reporters.
“I want to emphasize ... that the FOMC will adjust policy to what it actually sees unfolding in the economy over time,” Yellen continued.
Further underscoring the air of “uncertainty,” Yellen was conspicuously more nebulous about what the FOMC means by saying it will keep the funds rate near zero “for a considerable time” after QE3. In March, she said that period meant “around six months.” Now, she says, “there is no mechanical formula whatsoever for what a considerable time means....It depends on how the economy progresses...”
But no one should get the idea that Yellen and the FOMC majority are in any hurry to tighten credit. While she was fairly upbeat about the economy’s prospects, she made clear she is still concerned about the large number of “discouraged” workers and the duration of unemployment. Nor did she give any indication she is alarmed about upticks in inflation or risks to financial stability.
While pointing to low levels of market volatility, narrower junk bond yield spreads and increased leveraged lending, Yellen said, “if the question is to what extent is monetary policy at this time being driven by financial stability concerns, I would say ... I don’t see them shaping monetary policy in an important way right now.”
On net, despite Yellen’s caveats about monetary policy uncertainty, it seems safe to assume that for quite some time rates will be kept very low and “below normal”—whatever that means.
Steve Beckner is senior correspondent for Market News International. He is regularly heard on National Public Radio and is the author of “Back From The Brink: The Greenspan Years” (Wiley).