After the conclusion of the recent meeting of the Federal Open Market Committee, Fed Chair Janet Yellen outlined the fact that interest rates may be lower in the future than in the past. The Fed would likely move at a gradual pace, and reach a lower equilibrium level than what many investors who were accustomed to higher rates, such as in the 1980s (and that includes me too), might expect.
The rate that prevails at which neither inflation would accelerate nor growth would falter (absent any external shocks, of course) is the neutral interest rate. It can't be determined precisely in advance; often, policymakers and the markets determine it almost by trial and error. If inflation creeps (or jumps) up, interest rates are too low. If the economy struggles to gain momentum, rates are too high.
And that rate may not be that far above zero. Consider the current environment. The current Fed funds rate is just 0.25% to 0.5% - yet inflation has, thus far, failed to accelerate to the Fed's 2% target. Instead, the inflation rate the Fed prefers (which is tied to personal consumption expenditures and is published by the Bureau of Economic Analysis) notched up a gain of just 1.1% in April from a year ago. Even excluding food and fuel, the measure printed a 1.6% gain on the year.
There are few indications inflation may rise from here, even as the labor market is tightening. For example, the employment cost index indicated that private employers' wage and salary costs rose just 2.0% over the year through March 2016, compared to a 2.8% advance in March 2015. (This measure is published quarterly.) While other data on labor costs may yield slightly different data points, the end result is the same: wage pressures have yet to rise significantly to cause the Fed to seek to tighten rates more aggressively now. And that was one reason why the Fed chose not to act at its June meeting.
But how high can rates go, and what would cause them to get there? A primary issue, as Janet Yellen pointed out, is that the population is aging, and thus resulting in a slower growth environment as spending falls for retired workers no longer collecting a salary. Then too is the lack of productivity gains, which results in lower pay raises for workers, resulting in less spending power to generate higher economic activity. Both these factors conspire to keep inflation low, and without higher inflation, it will be hard for the Fed to justify higher rates.
Additionally, consider the market's expectations for inflation, which are remarkably low, as seen in this nearby graph. This chart measures what investors think inflation will be in the five years beginning five years from now, known as the "five-year, five-year forward" inflation rate.
So, in consideration of these items, the Fed anticipates that the long-run neutral interest rate is about 3% or so, depending on each policymaker's views. It may take several years to get there, and these expectations are based on current thinking now. It may evolve as time progresses and new data are released. Since the Fed stresses it is data dependent, it may or may not end up at 3%; the rate may be higher or lower depending on how the data evolve.
Thus, there may be a plausible argument for thinking that rates may not go up much from here, at least in the near future. After all, if we struggle to get to a 2% growth rate that can't produce higher inflation with the Fed funds rate where it is (that is, between 0.25% and 0.5%), then it may be difficult for the Fed to raise rates much from here. And that is the ultimate judge: if interest rates now fail to produce the stronger growth and inflation that the Fed would like to see, then that argues not for hiking rates quickly, but perhaps being much more patient. And for that reason, the Fed is likely to wait until it becomes apparent whether the current rate is, in fact, the "new neutral."
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