Analysis: R* Widely Cited Reason for Slow-walking Rate Hikes

By Steven K. Beckner

NEW YORK(MNI) – In the annals of monetary policymaking, economic precepts and catchphrases come and go, some seemingly having more staying power than others, but few have equaled the current popularity of "r*".

R* is not really new, of course. It’s just shorthand for a concept that’s been around a long time — the "natural rate of interest," otherwise known as the "real equilibrium short-term interest rate," the "normal" rate or the "neutral" rate.

But r* has been getting more and more attention from Fed policymakers the closer they’ve gotten to raising the federal funds rate from the zero to 25 basis point target range it’s been in since December 2008.

With the Fed’s rate-setting Federal Open Market Committee set to "actively consider" an initial rate hike at its Dec. 15-16 meeting, as Chair Janet Yellen has put it, the level of the real equilibrium or normal rate, r*, has become a regular feature of policymaker commentary.

That’s because r* is seen as a key component of the nominal funds rate going forward. If r* is believed to be lower, that implies less need to raise the funds rate, though not necessarily a reason to keep it near zero.

Theoretically, r* (the real equilibrium short-term interest rate) is the market-clearing rate of return which investors expect to receive over time and the rate at which the economy can grow at its non-inflationary potential.

Over time, the equilibrium real rate has averaged around 2%, but it can vary due to such factors as changes in productivity, changes in demand for capital, changes in the economy’s growth "potential and so forth.

Global forces may be at work as well. Fed Governor Lael Brainard contends the decline in foreign interest rates, by increasing demand for U.S. assets and putting upward pressure on the dollar "implies downward pressure on the U.S. neutral rate."

When FOMC participants go through their quarterly exercise of estimating the longer run funds rate, as they will do again at the mid-December meeting as part of the revised Summary of Economic Projections, they essentially make their best guess at what r* is and add the Fed’s 2% inflation target.

Importantly, FOMC assessments of the longer run funds rate have come down considerably in recent years — not because the inflation target has come down (it hasn’t), but because estimations of the real rate component (r*) have fallen.

In January 2012, when the FOMC first began announcing funds rate projections, 16 of 17 participants put the longer run rate at 4% or higher, with six estimating it at 4.5%. Only one had it at 3.75% or lower.

As recently as the March 19, 2014 SEP, a majority of FOMC participants still estimated the "longer run" or equilibrium funds rate to be at least 4%.

But FOMC participants lowered their median estimate of the longer run funds rate to 3.75% in June 2014, and in the September 2015 SEP, it was reduced further to 3.5%.

At 3.5%, the actual effective funds rate of roughly 13 basis points is is 337 basis points below "normal," but based on recent officials’ comments it would not be surprising if FOMC participants were to further lower their estimate of the longer run funds rate in the Dec. 16 SEP.

Thomas Laubach, director of the Federal Reserve Board’s Division of Monetary Affairs, seemed to suggest the longer run funds rate assumption is still too high in comments at the Kansas City Federal Reserve Bank’s Jackson Hole symposium at the end of August.

Laubach, who has published research on the equilibrium funds rate with current San Francisco Fed President John Williams, said the Fed staff’s estimates of the equilibrium funds rate "have been depressed and show no signs of returning."

Williams himself, in Nov. 21 comments at the University of California-Berkeley, contended that r* is "zero" and possibly lower. New York Fed President William Dudley has also estimated r* at zero.

The FOMC has been saying for some time it "anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

In keeping with that pledge of keeping the funds rate "below normal,", FOMC participants’ median assessment of the "appropriate" funds rate at the end of 2018 was put at 3.4% in September — 10 basis points below the longer run estimate.

But if the FOMC lifts off on Dec. 16, as is widely expected, Yellen and her colleagues are likely to reemphasize their intention to move rates higher very gradually. That could mean a still lower estimate of the longer run rate, as well as lower projections for the actual funds rate over the next three years.

Fed policymakers have been citing lower r* estimates as a justification for such gradualism — not necessarily for further delaying liftoff but for a shallow path of subsequent rate hikes.

Most recently, Brainard said "the slow progress on inflation, together with the likely low level of the longer-term neutral real rate and the slow pace at which the very low shorter-term rate may move to the longer-term rate, suggest that the federal funds rate is likely to adjust more gradually and to a lower level than in previous expansions."

"In short, "gradual and low" is likely to be the new normal," Brainard said Tuesday night.

She also argued "it would be prudent to maintain reinvestments until the normalization of the federal funds rate is sufficiently far along to allow room to cut nominal rates if economic conditions deteriorate."

Williams has indicated a greater willingness than Brainard to leave the zero lower bound, but has also argued for a gradual pace of rate hikes. And, in response to a question from MNI, he cited the low level of the real equilibrium short-term interest rate as one reason not to shrink the $4.5 trillion Fed balance sheet.

Maintaining a larger than normal balance sheet might serve as "a replacement for stimulus in short-term rates," he said.

Dudley said last month that one reason for a "quite gradual" pace of rate hikes is "because monetary policy is not as stimulative as the low level of the federal funds rate might suggest."

Estimating r* at "around zero percent," Dudley said "the likelihood that long-run r* is lower than it has been historically, suggests that after lift-off the upward trajectory of the short-term rates is likely to be quite shallow."

 

Ashley Joye Managing Partner T +44 (0)20 7422 2975 M +44 (0)7796 308 391 E ashley.joye@archr.com 49 Carnaby Street, London, W1F 9PY United Kingdom ARCHR.COM