Chicago Fed chief: Low interest rates to be a fixture in economy
Since the Federal Reserve announced its first increase in the federal funds rate in nine years, much of the focus has been on how gradually the Fed will raise interest rates in the 2016 calendar year. The consensus view is gradually, and given the continuing need for “accommodative” monetary policy consumers and investors also should expect long-run interest rates to be lower than previous estimates.
So says Charles Evans, president and CEO of the Federal Reserve Bank in Chicago. Evans delivered his economic forecast in Madison during a Jan. 7 keynote at the Wisconsin Bankers Association’s annual Wisconsin Economic Forecast Luncheon.
It was Evans’ first scheduled public speech since the Fed raised the federal funds rate in December, and it was delivered on the same day the Dow Jones dropped 400 points based on worries about China’s economy. The first week of 2016 was rocky for the Dow Jones Industrial Average, which plummeted 1,000 points despite the American economy’s positive job creating performance in December, when nonfarm payroll employment rose by 292,000.
Yet lower GDP forecasts were baked in the cake before last week’s shaky economic reports and the anticipation of less-than-stellar earnings reports in the early part of 2016. As recently as January 2012, Evans noted that the Federal Reserve’s Federal Open Market Committee (FOMC) participants assessed the long-run potential growth rate of the economy to be in the 2.25% to 3% range. Today, he says the median participant believes the longer-run real GDP growth is only 2%.
“Even the most optimistic of my colleagues places this number only slightly higher, at 2.3%,” Evans noted. “When measured against these benchmarks, my forecast for growth rising in the 2.0% to 2.25% range in 2016 doesn’t look so bad. It’s simply saying that the economy will expand near its longer-run productive capabilities.”
Evans conceded these growth estimates are disappointing, but added there is nothing much that monetary policy can do about the working-age population growth, labor force participation trends, or technological progress. In December, the labor force participation rate was at 62.6% and has shown little movement in recent months after reaching 30-year lows.
“These trend estimates are the benchmarks that we in the Federal Reserve have to take as given when deciding how to set monetary policy,” Evans stated. “That’s not to say, however, that these benchmarks do not influence policy. At face value, these trends imply that market determined interest rates are likely to be much lower over time than they have previously been.”
How do we rate?
Interest rates charged to consumers are based on the federal funds rate. It is the benchmark rate at which banks and credit unions lend reserve balances to other depository institutions overnight on an uncollateralized basis. As was illustrated in December, the federal funds target rate is determined by a meeting of FOMC members to influence the supply of money in the U.S economy.
While the federal funds rate is expected to rise in 2016, it is likely to remain relatively low as part of an “accommodative” monetary policy in which the Federal Reserve attempts to expand the overall money supply to boost economic growth. Before December, the Fed had not raised federal funds rate in more than nine years so that money was less expensive to borrow for consumers and businesses.
By now, however, many expected rates to be higher. “Three years ago, when forecasts of potential growth were higher, the committee was projecting a higher long-run federal funds rate, and that it would be in the range of 3.25% to 4.5%,” Evans noted. “That’s about half a point higher than today’s estimates.”
The economy is headed toward a lower resting point with the federal funds rate and gradual adjustments will be made to get there. Even though the Fed is nearing its mandate for full employment, or about 4% unemployment, and the economy created 292,000 new jobs in December (with the unemployment rate unchanged at 5.0%), gradual increases are the order of the day. By the end of 2016, Evans noted that “median participants” envision the federal funds rate to be about a percentage point higher than it is today, having been raised 25 basis points at every other FOMC meeting. The committee meets eight times per year.
“By historical standards, this is certainly a gradual path,” Evans stated. “It’s even slower than the so-called measured pace of increases that we affected over the 2004–06 tightening cycle, which was 25 basis points at each meeting, and that was heavily criticized for being too slow at the time.”
Why will Fed policy remain largely accommodative, even though the quarter of a point increase in the federal funds rate signals the start of a tightening cycle? Evans cited remaining fallout from the financial crisis, international headwinds, and historically low inflation that’s running well below the Fed’s target inflation rate of 2%.
“By some estimates, the normal inflation-adjusted rate is currently near zero,” he noted. “This rate should rise gradually as the headwinds fade, the economy becomes even stronger, and fundamentals improve even more. Until they do, monetary policy must be even lower than it otherwise would be to provide adequate accommodation for economic growth.”
Full employment and price stability are the dual mandates the U.S. Congress has set for the Federal Reserve. While the Fed is approaching its goal of full employment, it has consistently failed to reach its target for inflation, which has averaged 1.5% over the past eight years. The latest inflation reading was just four-tenths of one percent (0.4%), which is almost zero.
According to Evans, that’s due in part to lower energy prices and a stronger dollar. There might be more appreciation of the dollar and further declines in energy as leading oil producers like Saudi Arabia ramp up oil production to drive down gasoline prices and undercut higher-cost shale oil from American producers, but Evans doesn’t see these as long-lasting trends.
“I expect these affects to dissipate as we move through the year,” Evan predicted. “Improvements in labor markets and growth in economic activity should also boost inflation, and so I see inflation moving up gradually to approach our 2% inflation target over the next three years.”
Another downside risk is that undershooting the 2% inflation target for a prolonged period invites the risk of the public beginning to expect persistently low inflation. “If this mindset becomes embedded in decisions regarding wages and prices, then getting inflation back to 2% will be that much more difficult,” he noted.
A gradual path to policy normalization, he argued, is needed to achieve the inflation target and to provide a buffer against downside risks.
Evans acknowledged that he’s somewhat less optimistic about meeting the inflation target than most of his Fed colleagues. “Given the persistently low inflation record of the past six years, and given how slowly inflation evolves when it’s at such low levels, it may be difficult to return inflation to target over the next two to three years,” he stated. “I’m in favor of very gradual policy normalization to help ensure that we meet our inflation goal within a reasonable amount of time.
“Moreover, as I’ve argued many times, prudent risk management calls for a slower removal of accommodative monetary policy. From my perspective, the costs of raising the federal funds rate too quickly far exceed the costs of removing accommodation too slowly.”
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