Interest Rates’ ‘New Normal’
Art by Andrea D’Aquino
Watchers of the Federal Open Market Committee (FOMC) know its “Statement on Longer-Run Goals and Monetary Policy Strategy” articulates its approach to financial policy and serves as the foundation for its policy actions. Thus, a change to the statement, however minor, is generally viewed as a significant policy development.
In a speech given by Federal Reserve Chair Jerome Powell, he said the latest changes reflect the evolution in the U.S. and global economies over the past decade—and lessons learned in conducting monetary policy since the Great Recession. “The updated statement is also intended to enhance the transparency, accountability and effectiveness of monetary policy,” Powell said.
During his speech, Powell observed how the general level of interest rates has fallen. He said estimates of the neutral federal funds rate—i.e., the rate consistent with the economy operating at full strength and with stable inflation—have fallen substantially. This, in large part, reflects a fall in the “equilibrium real interest rate,” or “r-star,” he said.
Powell explained that this rate is not affected by monetary policy, but instead is driven by fundamental factors in the economy, including demographics and productivity growth—the same factors that drive potential economic growth. He noted that the new policy is largely in response to the nearly 50% drop, since 2012, in FOMC participants’ median estimate of the neutral federal funds rate—from 4.25% to 2.5%.
“This decline in assessments of the neutral federal funds rate has profound implications for monetary policy,” Powell said. “With interest rates generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate. The result can be worse economic outcomes in terms of both employment and price stability, with the costs of such outcomes likely falling hardest on those least able to bear them.”
Rupert Thompson, chief investment officer (CIO) at Kingswood Group, says the changes can be seen as a “refinement.”
“Rather than having a simple 2% inflation target as before, [the FOMC] is moving to an average inflation target of 2%,” he emphasizes. “It will now allow inflation to overshoot for a while following a period of undershooting, as has been the case in recent years. The Fed has also tweaked its full employment objective, increasing its tolerance of employment running at or above its maximum level. These moves were not entirely unexpected and are a bid to step up the effectiveness of its monetary policy, which is being compromised now that rates are so low.”
Echoing what seems to be commentators’ consensus, he says the changes make it even more likely that rates will stay at their “exceptionally low levels” for the next few years—maybe longer.
Technical Changes to the FOMC Strategy Statement
Among the more significant changes to the Federal Open Market Committee (FOMC) framework document are the following:
- The FOMC has stressed that maximum employment is “a broad-based and inclusive goal” and states that its policy decisions will be informed by its “assessments of the shortfalls of employment from its maximum level.” The original document referred instead to “deviations from its maximum level.”
- Of particular import to retirement savers and institutional investors: As to price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2% by noting that it “seeks to achieve inflation that averages 2%, over time.” To this end, the revised statement says, “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
- Other updates explicitly acknowledge the challenges for monetary policy posed by a persistently low interest rate environment. —JM
Historical Inflation Rates, by Percent, 1979 – 2019
14%
12%
10%
8%
6%
4%
2%
0%
-2%
1980
1985
1990
1995
2000
2005
2010
2015
14%
12%
10%
8%
6%
4%
2%
0%
-2%
1980
1985
1990
1995
2000
2005
2010
2015
14%
12%
10%
8%
6%
4%
2%
0%
-2%
1980
1985
1990
1995
2000
2005
2010
2015
14%
12%
10%
8%
6%
4%
2%
0%
-2%
1980
1985
1990
1995
2000
2005
2010
2015
Source: usinflationcalculator.com
| Looking Back at the FOMC |
➜ The Federal Open Market Committee (FOMC) first adopted a framework statement to set forth its monetary policy in 2012. ➜ The statement’s first public review was announced by Chair Jerome Powell in 2018. It involved three distinct components. ➜ First, the Federal Reserve hosted a series of 15 “Fed Listens” events to hear a range of perspectives about how monetary policy decisions affect various communities. ➜ Second, the Fed, a year ago June, convened a conference at which academic experts addressed topics central to the review. ➜ Third, starting that July, the committee explored the issues revealed during the review. Analytical staff work provided background for the discussions. ➜ The FOMC intends to, similarly, undertake a public review of its monetary policy strategy, tools and communication practices roughly every five years.
|