MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise

Federal Reserve officials are debating the possibility that the long-term neutral rate of interest has moved higher after the global pandemic and fiscal largesse that followed, a shift that, if confirmed, could herald a return to the considerably higher interest rates that characterized the 1990s.

Economists generally agree the short-run natural rate -- one that neither stimulates nor depresses growth -- has risen due to excess savings during the pandemic and a lengthening of the credit channel of monetary policy transmission after borrowers locked in low fixed-rate loans during Covid. (See: MNI INTERVIEW: Fed Probably Needs A Bit More Tightening-Aikman)

Official rates have jumped over five percentage points from zero in a year and a half with apparently little harm to the red-hot labor market and growth momentum. This raises the chance that a higher short-term r-star could transmit into the longer-run rate, signaling a more permanent change which would have to be incorporated into FOMC rate-setting calculations.

REGIME SHIFT

"A good question is whether the pandemic was a big enough shock and a global enough shock to knock us out of the low real-interest-rate equilibrium that we appeared to be in during the 2009 to 2019 period, and I think the tentative evidence is yes," former St. Louis Fed President James Bullard, who left the Fed in July, told a National Association for Business Economics webinar last week.

"You had a very strong response from around the world, especially in the U.S. but around the world, and the response was so large in fiscal terms and in monetary terms that you ended up with a lot of inflation that was unanticipated, so that may be the catalyst that has knocked us out of the low-real-interest-rate-regime world."

Former Treasury Secretary Larry Summers has also argued that higher deficits, partly due to more defense spending as well as rising investment in energy and artificial intelligence, are pushing up the natural rate.

Market participants and Fed watchers will be on the lookout for any upward adjustments to the Fed's estimate of the long-run neutral rate in the September Summary of Economic Projections, to be published alongside the policy decision next week.

"If it moves up, expect change to be very modest. But definitely something I will be checking," former New York Fed President William Dudley told MNI.

While the median estimate, which does not factor in inflation, has been stuck near 2.5% since June 2019, a growing minority of policymakers have expressed the view that it could now potentially be as high as 3.5%-3.75%. The range of estimates has edged higher, spanning 2.4%-3.6% in the June projections, up from 2.0%-3.0% a year earlier.

CAUTIOUS APPROACH

Given the difficult of gauging unobservable variables, Fed Chair Jerome Powell favors a cautious approach while awaiting clear evidence of persistently above-target inflation as policymakers determine whether to delay or slow rate cuts next year. (See: MNI INTERVIEW: Fed Will Hold For Long, Could Hike More- Hoenig)

"We cannot identify with certainty the neutral rate of interest, and thus there is always uncertainty about the precise level of monetary policy restraint," Powell told the Jackson Hole symposium last month. "As is often the case, we are navigating by the stars under cloudy skies. In such circumstances, risk-management considerations are critical."

Others including John Williams, the influential New York Fed President, argue longer-run r-star hasn't much budged in real terms from the 0.5% level that prevailed for more than a decade before Covid-19. The Holston-Williams-Laubach model, updated earlier this month, estimates real r-star at 0.57% in the second quarter.

The co-authors "do not find evidence that the era of historically low estimated natural rates of interest has ended," they said in a paper updating their model to account for the Covid supply shock.

Long-term demographic trends in rich nations that contributed to the broad decline of r-star after the financial crisis haven't shifted substantially either, economists say.

The structural reverberations of the pandemic may still be too recent to assess with any precision, the sentiment underpinning Powell's more conservative approach. In his first Jackson Hole speech as Fed chair in 2018, Powell also expressed skepticism about putting too much emphasis on "imprecise estimates of the stars" in forging policy.

“When you are uncertain about the effects of your actions, you should move conservatively,” he said. “In other words, when unsure of the potency of a medicine, start with a somewhat smaller dose.”