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Monday, October 12, 2015

'Why So Slow? A Gradual Return for Interest Rates'

This Economic Letter from Vasco Cúrdia of the SF Fed finds that even though interest rates are very low, so is the natural rate of interest, and that implies that monetary policy is "relatively tight."  "The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast":

Why So Slow? A Gradual Return for Interest Rates: Short-term interest rates in the United States have been very low since the financial crisis. Projections of the natural rate of interest indicate that a gradual return of short-term interest rates to normal over the next five years is consistent with promoting maximum employment and stable inflation. Uncertainty about the natural rate that is most consistent with an economy at its full potential suggests that the pace of normalization may be even more gradual than implied by these projections.
To boost economic growth during the financial crisis, the Federal Reserve aggressively cut the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero around the beginning of 2009. Since then the time projected for the rate to return to more normal historical levels has been continually postponed.
To understand the level of the federal funds rate and when it might be normalized it is useful to consider the concept of the natural rate of interest first proposed by Wicksell in 1898 and introduced into modern macroeconomic models by Woodford (2003). The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (overutilization) of resources and inflation below (above) its target.
This Economic Letter analyzes the recent behavior of the natural rate using an empirical macroeconomic model. The results suggest that the natural rate is currently very low by historical standards. Because of this, monetary conditions remain relatively tight despite the near-zero federal funds rate, which in turn is keeping economic activity below potential and inflation below target. The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast. ...

And the conclusion:

... This Letter suggests that the natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.

    Posted by on Monday, October 12, 2015 at 01:31 PM in Economics, Monetary Policy | Permalink  Comments (34)


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