For anyone whose financial memory dates back to a time when the overnight interbank rate was in double digits, the Federal Reserve’s announcement last month that zero was here to stay was nothing short of stunning.
To wit, the funds rate isn’t going to budge at least until the unemployment rate drops to 6.5 percent. (There are other contingencies that I’ll get to later.) Minneapolis Fed President Narayana Kocherlakota wants a 5.5 percent unemployment threshold. Anyone for 5 percent? Do I hear 4.5?
This is a new world. In the old days, economists thought it would require a 4 percent to 4.5 percent funds rate to keep the economy growing at its noninflationary potential. The idea that the funds rate would be at zero with the economy close to full employment — 5 percent to 6 percent, according to the Fed’s long-term economic projections — would have been almost heretical. Who in his right mind would buy a 10-year Treasury note yielding 1.8 percent if he thought the funds rate was on its way to 4 percent?
The Fed is convinced it can prevent any adverse market reaction by adopting an upper limit of 2.5 percent for inflation in addition to its unemployment threshold.
One group of economists was pleased with the Fed’s decision to provide explicit goals for monetary policy last month. These so-called market monetarists would have preferred a nominal gross-domestic-product target, encompassing real growth and inflation. But the new thresholds are an improvement over the central bank’s traditional dual mandate of stable prices and maximum employment.
Color me skeptical. When I read the 82-word sentence outlining conditions to be met before the Fed would start raising rates, all I could think of was Winston Churchill’s description of the Soviet Union: “a riddle, wrapped in a mystery, inside an enigma.” I doubt the Fed will unwrap it when it meets this week.
Here’s my issue. The new thresholds are a combination of an official government statistic (the unemployment rate) that is affected by both cyclical and structural forces, with different implications; a forecast (the Fed’s) of inflation one to two years out; and a market-based indicator of inflation expectations. For an institution that is focused on communication as a policy tool, the Fed should be able to state its target in a dozen words or less. Otherwise, how is the public supposed to understand and alter its behavior accordingly to help the Fed achieve the desired goals?
I called Scott Sumner, professor of economics at Bentley University in Waltham, Mass., and an advocate of nominal GDP targeting, for enlightenment. He says he views the Fed’s willingness to keep interest rates at zero for such an extended period as “a backdoor way of nominal GDP level targeting. The Fed would like a catch-up in growth before it starts tightening.”
With a nominal GDP target, the Fed would set an appropriate rate of growth for nominal income. Under a level-targeting regime, the central bank would encourage above-target growth to offset any periods of weakness. Fed Vice Chairman Janet Yellen, considered a likely successor to Chairman Ben Bernanke when his term ends in a year, has talked about an “optimal control path” for monetary policy in recent speeches. It’s “equivalent to a nominal GDP level target,” Goldman Sachs economists said in a Jan. 20 research report. And it’s something “market participants have so far failed to grasp.”
While I was trying to do just that, to see the new thresholds as an intermediate step en route to a simpler, clearer target, Sumner gave me more to think about. He believes that slow nominal and real growth accompanied by ultra-low interest rates are less a temporary phenomenon than the norm in developed nations with aging populations. Think Japan in the last two decades. The Bank of Japan tried to move its benchmark rate away from zero in 2000 and again in 2006, only to find its actions premature.
Like Japan and Europe, the United States is experiencing a “long-term secular decline in real interest rates, from 7 percent to negative 1 percent now, at the same time inflation has been trending down,” he said.
What that means is 3 percent 30-year Treasury bonds are the “new normal,” a phrase I try to avoid. Normal implies that low yields are less a function of the Fed’s long-term asset purchases than investors’ expectations of low nominal GDP, Sumner said.
Sumner’s framework has implications for fiscal policy, as well. A permanent state of slow growth makes it harder for the United States to fulfill its promises to the elderly, not to mention invest in education and other priorities. The unemployed and underemployed will become even more reliant on the federal government. Savers will be denied the benefit of compounding interest.
If Sumner’s world view is correct, and this is a new era, all the old premises will have to be tossed. A funds rate at zero with the economy at full employment? If the Fed has learned to stop worrying and love zero, I guess we can, too.