The Fed released the minutes from its latest policy meeting on Wednesday. The minutes are usually a snooze-fest. They tell the public about the economic outlook of Fed staff economists and the policy makers who set interest rates. Fed minutes make SEC company filings read like a Tom Clancy novel. You have to be seriously caffeinated to get them without inadvertently dozing off. I’m talking Starbucks red-eye caffeinated here—Folgers won’t cut it.
When the minutes were released this week, the stock market immediately rallied. The initial press reports were confused. Some reports attributed the rally in stocks to a lower likelihood of a hike in December. Others said the Fed’s confidence in the economy bolstered investor confidence.
Neither sounded credible. The probability of a rate hike based on Fed Funds futures prices didn’t budge much. And short-term Treasury yields didn’t move much. So based on the bond market reaction, the likelihood of a rate hike in December didn’t change.
The notion that Fed confidence in the economy would bolster investor confidence is a mistake that the press often makes. The market doesn’t take its cue from Yellen and Co., it is most often the other way around.
So then, why the positive reaction to the Fed minutes? It is all contained in the first four paragraphs of the minutes included at the end of this post. The Fed staff gave briefings on the so-called neutral policy rate.
The neutral rate is the goldilocks rate of interest. It keeps the economy from getting too hot or too cold. Historically, the Fed has assumed the neutral real rate of interest is 2%. Add inflation of 2% and you get a 4% nominal rate which is the rate that investors actually earn when they invest money.
The minutes threw that 2% assumption on its head. Using fancy statistical methods, the Fed’s economists estimate that the neutral rate of interest is now close to zero and will only gradually move back toward historical norms.
This is a huge deal if the policymakers at the Fed buy the staff’s projections. It means the Fed thinks zero rates aren’t so stimulative, and that the Fed Funds rate may end at a much lower level during this hiking cycle than in past cycles. It also gives Yellen & Co. cover for keeping rates at zero for much longer than has been necessary and for their plan to hike rates at snail’s pace.
We don’t know yet if this was just an academic exercise or part of a larger plan to give FOMC members justification for lowering their long-run Fed Funds rate expectations. Investors will want to look for changes in FOMC members’ long-run policy rate assumptions following the December Fed meeting.
The idea that the neutral rate of interest is 0% before inflation seems misguided. It is emblematic of an economics profession that has in recent decades put too much weight on empirical studies and too little weight on sound theory and common sense. You see it in the minimum wage debate. It doesn’t matter what the data says (statistical models are prone to error and can’t account for everything), when you raise the price of labor you get less of it.
A neutral policy rate of 0% also wouldn’t seem to hold up under the spotlight. Are the Fed’s 200 PhD economists really saying that money has no opportunity cost? That would seem to fly in the face of centuries of economic history.
This all sounds a bit too much like a “this time is different” tune. Those are dangerous words in the investment profession. Let’s hope the same is not true in economics.
Equilibrium Real Interest Rates
The staff presented several briefings regarding the concept of an equilibrium real interest rate–sometimes labeled the “neutral” or “natural” real interest rate, or “r*”–that can serve as a benchmark to help gauge the stance of monetary policy. Various concepts of r* were discussed. According to one definition, short-run r* is the level of the real short-term interest rate that, if obtained currently, would result in the economy operating at full employment or, in some simple models of the economy, at full employment and price stability. The staff summarized the behavior of estimates of the short-run equilibrium real rate over recent business cycles as well as longer-run trends in real interest rates and key factors that influence those trends. Estimates derived using a variety of empirical models of the U.S. economy and a range of econometric techniques indicated that short-run r* fell sharply with the onset of the 2008-09 financial crisis and recession, quite likely to negative levels. Short-run r* was estimated to have recovered only partially and to be close to zero currently, still well below levels that prevailed during recent economic expansions when the unemployment rate was close to estimates of its longer-run normal level.
With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies. Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out. Finally, the staff discussed the implications of uncertainty about the level of the equilibrium real rate for using estimates of short-run r* as a guideline for appropriate monetary policy.
In their comments on the briefings and in their discussion of the potential use of r* in monetary policy deliberations, policymakers made a number of observations. The unemployment rate has declined gradually in recent years, indicating that real gross domestic product (GDP) growth has, on average, exceeded growth of potential GDP, but not by a substantial margin. This outcome, in turn, suggested that the actual level of short-term real interest rates has been below but not
substantially below the equilibrium real rate, consistent with estimates that r* currently is close to zero, notably below its historical average.
A number of participants indicated that they expected short-run r* to rise as the economic expansion continued, but probably only gradually. Moreover, it was noted that the longer-run downward trend in real interest rates suggested that short-run r* would likely remain below levels that were normal during previous business cycle expansions, and that the longer-run normal level to which the nominal federal funds rate might be expected to converge in the absence of further shocks to the economy–that is, the level that would be consistent, in the long run, with maximum employment and 2 percent inflation–would likely be lower than was the case in previous decades. A lower long-run level of r* would also imply that the gap between the actual level of the federal funds rate and its near-zero effective lower bound would be smaller on average. A smaller gap might increase the frequency of episodes in which policymakers would not be able to reduce the federal funds rate enough to promote a strong economic recovery and rapid return to maximum employment or to maintain price stability in the aftermath of negative shocks to aggregate demand. Some participants noted that it would be prudent to have additional policy tools that could be used in such situations.