This essay is also available on Medium.

An important question for monetary policymakers is: what policy stance, including the current setting of the federal funds rate, the current size and composition of the Fed’s balance sheet, and the expected trajectories of the federal funds rate and of the balance sheet, represents the “neutral” – neither stimulating nor slowing down the economy?

In our Summary of Economic Projections (SEP), participants in the Federal Open Market Committee (FOMC) estimate the long-term level of the federal funds rate, that is, the nominal overnight interest rate that best represents long-term neutrality, once the various shocks affecting the economy have passed. We cannot directly observe the rate of neutral funds; we can only estimate it. My own estimate of the nominal neutral funds rate is 2.0%, and the range of estimates in the most recent SEP among FOMC participants is 2.0% to 3.0%.

But is the nominal fed funds rate really driving economic activity, and therefore comparing it to our estimate of its longer-term neutral level, the best assessment we can make of the economy? current stance of monetary policy?

Most economists argue that it is not nominal rates that stimulate economic activity, but real rates: nominal rates minus inflation. And while the FOMC has raised the funds rate by 75 basis points in the past two meetings (to 75-100 basis points), inflation has climbed rapidly over the past year (Chart 1). Some observers say the Fed is way behind the curve because inflation has been climbing faster than we have been raising rates. Consequently, monetary policy did not tighten, but actually became more stimulative as inflation rose. So we’re not just behind the curve, they argue, we’re even further behind.

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Is this criticism fair?


While I agree that real rates are more important than nominal rates in stimulating economic activity, I think it’s real long-term rates – say 5 years, 10 years or more – rather than overnight rates day that influence business and consumer demand for credit. When companies consider taking out a loan to build a new factory, they consider their cost of capital over the life of the project to determine if the project is a good investment. Likewise, when families consider taking out a mortgage to buy a home, most don’t think about overnight interest rates. They take into account the interest rate they will have to pay for the mortgage over the term of the loan, which may be 10, 15 or even 30 years. Therefore, in my view, long real rates are much more important than short real rates in stimulating economic activity, and we should look at long real rates to assess whether policy is stimulating or holding back the economy. So what happened to real long rates?

Since the FOMC began changing its policy last fall, real long-term interest rates have risen significantly.

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Chart 2 shows that real long-term rates have risen rapidly in recent months. In fact, they rose even faster than they fell in the spring of 2020, when the FOMC cut the federal funds rate to virtually zero and launched a massive program of quantitative easing to support the economy. How is this possible given that we have only increased the funds rate by 75 basis points and have not actually started to reduce our balance sheet?

We see the power of forward guidance: the FOMC has signaled the direction of policy going forward, and markets have adjusted in anticipation of these policy changes, including both expected funds rate increases and balance sheet reductions. Since the FOMC enjoys strong credibility with market participants, they take our forward guidance seriously, as they should.

Just before the pandemic hit, the real 10-year rate was around 0%, and today it’s back to around 0% after falling to -1% during the pandemic at the height of monetary stimulus. the Fed. So where are we now with respect to neutral?

As I noted above, we cannot directly observe the neutral nominal fund rate. The same is true for the long-term neutral real rate. We can only try to estimate it. One approach is to look at “forward” real interest rates, which take into account that the effects of shocks have passed. The following chart shows the real 5-year 5-year rate, which is one of these proxies. You can see that it has been declining over the past 20 years (Chart 3).

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We know that neutral rates have fallen in advanced economies around the world due to factors beyond the influence of monetary policy, such as demographics, technological developments and trade. I think monetary policy was roughly neutral shortly before the pandemic. Real long-term rates have now returned to around this level.

So if I think we are close to neutral now, what does that mean for monetary policy in the future?

First, at a minimum, the FOMC needs to act on the forward-looking direction of fed funds rate hikes and balance sheet shrinking that we’ve already flagged in order to validate the price revision that’s been happening in the markets. financial.

Second, we will need to see if the supply issues that contributed to high inflation begin to unwind and/or if the economy is in a higher pressure equilibrium. I wrote about this possibility seven weeks ago. Unfortunately, news of the war in Ukraine and COVID lockdowns in China are likely delaying any normalization of supply chains. If supply constraints dissipate quickly, we may only need to pull policy back to neutral or slightly exceed it to bring inflation down. If they don’t unwind quickly or the economy is truly in a higher pressure equilibrium, we’ll likely have to push real long rates into a tight stance to balance supply and demand. Incoming data over the next few months should shed some light on these questions.

Finally, we will have to continue to assess where neutrality lies. If the economy is in fact in a higher pressure equilibrium, this could indicate that the real long-term neutral rate has risen, which would then require even higher rates to reach a contraction position that would balance the economy.

So how do I put it all together?

The FOMC has made a dramatic pivot in the overall policy stance over the past few months. The committee’s forward-looking guidance and strong credibility with market participants resulted in an even faster withdrawal of monetary stimulus than we added in the spring of 2020. Watch how mortgage rates have risen sharply as an indicator of how quickly with which monetary policy has tightened (Chart 4).

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We must now act on our forward directions, and I am confident that we will. We will have to watch the incoming data over the next few months to determine whether sticking to the current forecast is enough to lower inflation or if we will need to do more. I am convinced that we will do what it takes to bring inflation back to our target of 2%.


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