Yellen on Natural Rates

This is from Janet Yellen’s press conference:

This expectation is consistent with the view that the neutral nominal federal funds rate–defined as the value of the federal funds rate that would be neither expansionary nor contractionary if the economy were operating near potential–is currently low by historical standards and is likely to rise only gradually over time. One indication that the neutral funds rate is unusually low is that U.S. economic growth has been only moderate in recent years despite the very low level of the federal funds rate and the Federal Reserve’s very large holdings of longerterm securities. Had the neutral rate been running closer to its longer-run level, these policy actions would have been expected to foster a much more rapid economic expansion.

The marked decline in the neutral federal funds rate may be partially attributable to a range of persistent economic headwinds that have weighed on aggregate demand. Following the financial crisis, these headwinds included tighter underwriting standards and limited access to credit for some borrowers, deleveraging by many households to reduce debt burdens, contractionary fiscal policy, weak growth abroad coupled with a significant appreciation of the dollar, slower productivity and labor force growth, and elevated uncertainty about the economic outlook. Although the restraint imposed by many of these factors has declined noticeably over the past few years, some of these effects have remained significant. As these effects abate, the neutral federal funds rate should gradually move higher over time.

This view is implicitly reflected in participants’ projections of appropriate monetary policy. The median projection for the federal funds rate rises gradually to nearly 1-1/2 percent in late 2016 and 2-1/2 percent in late 2017. As the factors restraining economic growth continue to fade over time, the median rate rises to 3-1/4 percent by the end of 2018, close to its longer-run normal level. Compared with the projections made in September, a number of participants lowered somewhat their paths for the federal funds rate, although changes to the median path are fairly minor.

I think this is very important and I’ll try to explain why. Prior to the recession, it was assumed that the natural rate was about 2% in real terms, meaning after inflation.

That means that the Fed’s job is pretty simple: bring the Fed funds rate below 2% to get the economy going, and then bring it above 2% when the economy is running hot. As such, the trend of real Fed funds should oscillate between about 0% on the low end and 4% or so on the high end. Check out this chart:

After the recession hit, all that went out the window. The Fed believes that the natural rate tanked and probably went negative. I think that’s right.

Now the “sine wave” of real rates may fluctuate between, say, -2% and +2%. According to today’s blue dots, the Fed expects the real Fed funds rate (the blue line in the chart above) to be -0.9% at the end of this year. It will rise to -0.2% at the end of 2016, and to +0.5% by the end of 2017. The Fed believes the long-rate rate is 1.4% which we can assume is the Fed’s guess for the natural rate. I think that’s too high.

To me, what the new numbers are isn’t exactly important. It’s that we live in a new economic world. The old rules no longer apply.

Posted by on December 16th, 2015 at 5:33 pm


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