Last month the second-highest ranking monetary policy official in the United States, Federal Reserve Vice Chairman Stanley Fischer, gave a speech about the state of the American economy. Clearly most important for Mr. Fischer was productivity growth, which has slowed, and negative demographic trends, which both weigh on long-term growth potential.
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The implications for U.S. monetary policy are significant, Mr. Fischer said, because lower potential growth in gross domestic product means a reduction in r*. The latter is economists’ lingo for the “natural” or “neutral” level of interest rates. At this level, inflation remains at the central bank’s target and the economy operates at full capacity.
If r* is permanently lower – much lower – than we used to think five or 10 years ago, that implies the present low level of interest rates in the U.S. and the world is probably of a more permanent nature. And if that is true, current monetary policy might not be quite as “accommodative” as it is often said to be. In consequence, there would be little reason to hike interest rates in the U.S. anytime soon.
Mr. Fischer is not the first high-ranking Fed official to make such comments. In fact, it seems like a new consensus may be forming among members of the Federal Open Market Committee, which decides U.S. interest rates. In the past few weeks, Robert Kaplan, president of the Dallas Federal Reserve, and John Williams, president of the San Francisco Fed, have both stressed that r* is probably very low and that policymakers should take this into account.
Notably, Mr. Williams has suggested that the Fed might want to change its monetary policy target from inflation to nominal GDP. That would amount to a clear signal that the monetary authorities are in much less of a hurry to increase borrowing costs.
Even with interest rates historically low, they are not necessarily too low
These comments have been echoed by Federal Reserve Chair Janet Yellen. At the Kansas City Fed’s annual Economic Policy Symposium at Jackson Hole, Wyoming, she said that “by some calculations, the real neutral rate is currently close to zero, and it could remain at this low level if we were to continue to see slow productivity growth and high global saving.”
The logical consequence of this reasoning is that even with interest rates historically low, they are not necessarily too low. In fact, with inflation expectations well below 2 percent, an argument can be made for further monetary easing.
Even with such clear indications of change in the Fed’s thinking, some market observers still predict a rate increase this month. At the very least, next week’s FOMC meeting may shed more light on how seriously policymakers are treating potential economic growth and r*.