The St. Louis Fed has taken a new stance on monetary and macroeconomic policy. Dr. James Bullard, President of the St. Louis Fed, laid out the stance in a presentation to the National Association of Business Economists yesterday. The new stance is quite interesting with important implications for short-term interest rates. We thought we would briefly explain the stance in today’s commentary.
Let’s start with the old narrative as Dr. Bullard called it. In this model, the economy has a natural “steady state” governing growth, inflation, unemployment and interest rates. Over time the economy naturally gravitates to its “steady state.” When economic performance is below its “steady state”, Fed policy should keep policy rates (i.e. Fed Funds target rate) lower than normalized levels to help stimulate the economy. As the economy approaches its “steady state”, the Fed should increase policy rates toward their normalized levels. If the economy overshoots its “steady state”, the Fed should raise its policy rate above normalized levels to help bring the economy back to its “steady state.” Years ago, economists considered normalized rates in the money markets to be around 5%. Since the financial crisis, some economists have speculated that normalized rates are closer to 3%. In either case, those interest rate levels are far above today’s actual rates. Given that the economy now appears to be near “steady state” growth (~2-2.5%), unemployment (~4.5%) and inflation (~2%), under the old narrative the Fed should be moving its policy rate to the 3%-5% range.
The new narrative developed by the St. Louis Fed abandons the notion of a “steady state” for the economy. Instead, according to Dr. Bullard, an economy has many regimes that it may visit. Optimal monetary policy is regime dependent. Once a regime is achieved and identified, there is no need to change the policy rate during the forecast horizon (2 to 2.5 years) of the regime.
The question is, what fundamental factors determine a regime? According to Bullard, they are productivity growth, the level of real interest rates (defined as the yield on short term T-bills less inflation) and the state of the business cycle (defined as whether the economy is in recession or not). In the current regime, productivity growth is much lower than the historical average. Productivity has only grown at a 0.4% rate since 2011 versus an average of 2.3% from ‘95-’05. Real interest rates are abnormally low due to the willingness of investors to pay a high liquidity premium for risk-free assets post-financial crisis. Currently real interest rates in the US are around -141bps versus an average of 270bps from ‘84-’07. Finally, the St. Louis Fed believes there is only a 2-3% probability of a recession in the next two years.
So, in the current regime we find ourselves, how do we determine the most appropriate policy rate? The formula used by the St. Louis Fed under this new narrative is the following: The policy rate should be equal to the real rate of interest plus the target rate of inflation plus or minus a factor for the current GDP growth gap and the inflation gap. Since, according to Dr. Bullard, the economy is growing at its long-term trend level and current inflation is running very near the Fed’s target of 2%, the last two terms (GDP and inflation gaps) can be ignored. This means the policy rate for the next two years should be the real rate of interest (-1.41%) plus target inflation (2.00%) or around 0.69%. This implies one more 25bps tightening in the Fed Funds target rate some time in the next two years. This is very consistent with the current expectations of the Eurodollar and Fed Funds futures market. If the St. Louis Fed gets its way, low interest rates are here to stay.
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