In December 2008, the Federal Reserve took the specific policy interest rate that it targets--the so-called "federal funds interest rate"--down to the range of 0% to .25%. The Fed then held the federal funds interest rate at this near-zero level for seven years, until December 2015. Since then, the Fed has raised the federal funds interest rate eight times in small steps, with the most recent step at its September 27 meeting, so that it now is in the range of 2% to 2.25%. How much higher is the Fed going to go?
Short answer: Four more interest rate increases by the end of 2019, taking the federal funds interest rate up to the level of 3% to 3.25%.
Longer answer: Robert S. Kaplan of the Dallas Federal Reserve explains in "The Neutral Rate of Interest" (October 24, 2018). Or for another nice explainer on the neutral rate, see
"The Hutchins Center Explains: The neutral rate of interest," by Michael Ng and David Wessel (October 22, 2018).
As Kaplan discussed, the Federal Reserve cut interest rates during the Great Recession and afterward, to stimulate the economy. But with the unemployment rate at 4% or less for the last six months, the Fed has been moving toward a "neutral" interest rate. Kaplan writes:
"The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability. You won’t find the neutral rate quoted on your computer screen or in the financial section of the newspaper. The neutral rate is an “inferred” rate—that is, it is estimated based on various analyses and observations."
So what are the Federal Reserve policymakers current inferring? At each meeting, the participants provide their own estimates of the neutral rate. Kaplan writes:
"Each of us around the FOMC table submits quarterly, as part of the Summary of Economic Projections (sometimes referred to as the SEP or the “dot plot”), our best judgments regarding the appropriate path for the federal funds rate and the “longer-run” federal funds rate. My longer-run rate submission is my best estimate of the longer-run neutral rate for the U.S. economy. In the September SEP, the range of submissions by FOMC participants for the longer-run rate was 2.5 to 3.5 percent, and the median estimate was 3.0 percent. My own estimate of the longer-run neutral rate is modestly below the median of the estimates made by my colleagues. My suggested rate path for 2019 is also modestly below the 3 to 3.25 percent median of the ranges suggested by my fellow FOMC participants."
So based on what Fed policy-makers are saying, that seems like what is likely to happen (of course, barring substantial shifts in the economy that would lead to a reevaluation of plans). But is it what should happen? Kaplan makes the case for his own view, which in part involves looking at some prominent economic models that try to estimate the "neutral" interest rate. Thus, he writes:
"These models differ in terms of their structural assumptions and the data they use to produce estimates of the neutral rate. For example, Laubach–Williams uses data on real GDP, core PCE inflation, oil prices, import prices and the federal funds rate as inputs for their model. This model attempts to estimate an output gap to assess the neutral rate of interest. The Koenig model uses data on long-term bond yields, survey measures of long-term GDP growth and long-term inflation as inputs for its estimates of long-run r*. Giannoni’s model uses a broad set of key macroeconomic and financial data series to generate estimates of the neutral rate at different time horizons."
All of these models suggest that the neutral interest rate is lower now than, say, 15-20 years ago, when it was more in the range of 5%. The estimates are surrounded by a reasonable degree of uncertainty. But they generally support Kaplan's argument that the Fed should continue along its current path of interest rate increases.
The Fed's decisions about raising interest rates since December 2015 have not been without controversy and dissent. Those who opposed raising the rates feared that the higher rates might slow the economy. But at least so far during the last few years, those skeptics have turned out to be mistaken in their concerns.
It's useful to remember that the specific interest rate on which the Fed focuses, the federal funds interest rate, is not a full summary of how easy or hard it is to borrow money. The Chicago Fed publishes a National Financial Conditions Index which looks at factors like total amount of loans, along with measures of leverage and risk. The pattern in the last few years is that although the Fed has raised its policy interest rate, credit conditions as a whole have actually been getting a little easier, not tighter. I tried to explain this pattern in "Rising Interest Rates, but Easier Financial Conditions" (February 15, 2018). The basic story is that the economy has been gaining strength, and the financial sector appears to have been reassured by the Fed's ongoing willingness to move to a neutral interest rate.
In other words, it is too simple to argue that higher interest rates always and automatically slow down an economy. When the higher interest rates reflect a bounce-back from historically low rates that were in place for seven years, returning those interest rates to more usual levels both reflects and supports economic strength.
A version of this article first appeared on Conversable Economist.
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