Shock and Awe from the FED

Yesterday, expecting ‘more-of-the-same’ comments from Janet Yellen at her press conference, I was shocked to hear her say, “A low neutral rate may be closer to the new normal.”

If you missed this comment – and its significance – you’re not alone.   But this is huge!

What is the “neutral rate”?    Read on …

Why you Should Care:  For years now, the FED has talked about ‘normalizing’ the federal funds rate – currently at .25% to .50%.   Normalizing means raising the rate – over time – to a short term rate closer to 3.00%.    Their ‘dot plot’ of ‘appropriate monetary policy’ suggest this would happen after 2018 – at some future time they call “the longer run“.   So, no time soon….  Regardless, this has been their vision of where short term rates should once again settle in – some day.    Until now.  The vision has changed.

Taking Action:  Adjust your future rate expectations.  Downward.

THE BLOG:   The neutral (or natural) rate of interest is the rate at which ‘real’ GDP is growing at its trend rate and inflation is stable.  In other words, the neutral rate is where GDP growth and inflation are in equilibrium.

According the the economist who first promoted this idea about 120 years ago, Knut Wicksell, interest rates are neutral when the economy is on a sustainable path.  Deviations from neutrality are what cause booms and busts.   Which means an ill-timed rate hike – if a deviation from neutrality – could trigger a recession.

OK…this isn’t really anything new.  The FED has been philosophically consistent with this theory for years.  They know that lifting interest rates chills economic growth.

What is new is Yellen’s overt comment, yesterday, that low rates are the new normal.   That’s new.  And that is a shocking concession by the FED Chairwoman.

Two of her compatriots at the SF FED wrote a paper on this topic in October of last year.   Entitled “Measuring the Natural Rate of Interest Redux” authors Thomas Laubach and John Williams summarized their findings as:

“Persistently low real interest rates have prompted the question whether low interest rates are here to stay.  Since the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering. These results are robust to alternative model specifications. If the natural rate remains low, future episodes of hitting the zero lower bound are likely to be frequent and long-lasting.  In addition, uncertainty about the natural rate argues for policy approaches that are more robust to mismeasurement of natural rates.“

Here’s the paper:

http://www.frbsf.org/economic-research/files/wp2015-16.pdf

And here is a great chart from the WSJ showing the FED funds rate overlaid on the Laubach/Williams neutral rate of interest forecast:

As I’ve been saying for some time now, at least for the foreseeable future, we’ve entered a new phase in global economic activity.  We’re on ‘simmer’.   Does the lower level of global growth cause a lower neutral (natural) rate to develop?   Or is it the other way around?

Or is it simply a vicious cycle, with each simply reinforcing the other?

It matters not.  What does matter is that the FED – finally – is now acknowledging ‘simmer’ in both GDP growth and interest rates is right where we belong.   For now.

• Terry Liebman