The “Short-run” Neutral Rate Debate: Little Effect on the Rate Path, If Any

Recently, the concept of a short-run neutral rate has reemerged in comments by Brainard. For example,  Brainard has recently said that headwinds have turned into tailwinds and, as a result, the short-run neutral rate will likely rise above its long-run estimate. On the other hand, Powell has emphasized the uncertainty about the estimate of the neutral rate. Williams has said that while estimates of the neutral rate were very useful earlier, they are less so today, thereby downplaying the guidance from estimated neutral rates altogether. Still, the median path of the fund’s rate and the estimate of the neutral rate, and remarks by many participants about the neutral rate suggest they continue to see their estimates as a guidepost for their rate projections. So, for now, Brainard’s views of the short-run fund’s rate are having little effect on what most members see as appropriate policy today. 

The Previous View: It’s about “Headwinds” 

The distinction between a short-run and long-run neutral rate was introduced into the FOMC’s policy discourse in 2015 by former Chair Yellen, who explained why the FOMC’s policy of keeping the fund’s rate target lower for longer near zero was warranted, even with the economy already in an extended expansion. The reasoning was that headwinds following the Great Recession were weighing on the economy and had to be offset by interest rates that were lower than would have been the case in normal times.1 As the headwinds dissipate,  the short-run rate was expected to rise to its long-run level. 

It’s Just about the Long-run Neutral Rate Again 

For a while, there was little discussion of a short-run rate, and it appears that FOMC participant’s rate projections were being guided by their respective estimates of the fund’s rate in the longer run. 

Now, It’s About “Tailwinds” 

Recently, Brainard reintroduced the distinction between a short-run and long-run neutral rate, using the same logic that Yellen did when the short-run rate was thought to be below the long-run rate.2 However, the sign of the discrepancy has flipped: She believes that the short-run neutral rate is likely to reflect tailwinds more than headwinds in the next couple of years, so it will rise to above its longer-run level. Here are Brainard’s remarks  on the short-run neutral rate (Sep. 12): 

1 That view, supported by Laubach and Williams, was very influential on FOMC participants and reflected in policy. Their paper was cited many times, and then replaced by a paper Laubach and Williams wrote with Holston. The latter paper estimated the neutral rate was close to ½%. 

2 Brainard, Lael (2018). “What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?” speech delivered at the Detroit  Economic Club, Detroit, Michigan, September 12. 

With government stimulus in the pipeline providing tailwinds to demand over the next two years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate.  

And Mester (May 31): 

It is short-run and it is a long run and that is a good way to be thinking about this. Given the strength in the economy, I can imagine the short-run r-star is going to be moving up, and therefore we’re going to want to move. And that is one argument for why we want to move up the fund’s rate because we don’t want to get behind the curve. In the long run, I’m at a 3% nominal fed funds rate. 

Evans, on the other hand, while also talking about a short-run neutral rate, was still focused on headwinds  rather than tailwinds (Jul. 11):  

It could be that the short-run dynamics are such that maybe it might be a little bit lower than that  2.75% on the way there. It’s going to depend on whether or not you think there’s still some type of headwind, some uncertainty. Trade policy could be part of that. But on the other hand, tax policy could be moving it in the other direction. Productivity growing more strongly if there’s a burst of innovation, that’s always difficult to forecast. But it appears when it appears. But it’s not too much less than 2.75% probably.  

Operational Equivalence? 

Frankly, when I read the Brainard speech, I had some misgivings. Brainard describes a response of the neutral fund’s rate to a one-time shock to demand, namely the fiscal stimulus. Generally, policymakers talk about such a shock as calling for a temporary increase in the fund’s rate relative to the neutral rate. The former talks about needing to raise the fund’s rate to keep up with the higher short-run neutral. The other is about wanting to raise the fund’s rate above the long-run neutral, which is presumably little changed. 3 

The two camps appear to reach the same conclusion about the fund’s rate in 2020 and 2021, but for different reasons. The Brainard camp perhaps interprets the projected move to 3½% as a rise in the short-run neutral rate above its long-run level of about 3%. It seems that most other participants see the move to 3½% as an increase in the fund’s rate to above its long-run neutral level; that is, into restrictive territory.  

Powell seemed to allude to these different ways of thinking about FOMC participants’ expected path of rate  increases (Sep. 26):  

Maybe we have underestimated the neutral rate. Maybe we will be raising our estimate of the neutral rate and we’ll just go to that, or maybe we will keep our neutral rate here and go two rate increases beyond. I think it’s very possible. 

But Do Estimates of the Neutral Rate Provide Guidance Today? 

Powell and Williams have recently downplayed the usefulness of estimates of the neutral rate.  

Powell has said, “Navigating by the stars can sound straightforward. Guiding policy by the stars in practice,  however, has been quite challenging of late because our best assessments of the location of the stars have  been changing significantly.” He later added, “These assessments of the values of the stars are imprecise and subject to further revision. To return to the nautical metaphor, the FOMC has been navigating between  

3 Complicating this story is that participants’ estimates of the long-run neutral have edged up, perhaps in part as a result of the expected persistent increase in the deficit-to-income and debt-to-income ratios, in line with economic theory and the empirical findings of Laubach Williams.

the shoals of overheating and premature tightening with only a hazy view of what seem to be shifting  navigational guides.” 

Williams recently said that while r-star was a “pole star” in previous times when rates were lower, it is now  “just one factor.” It’s still “a useful concept,” but now that the fund’s rate is higher, “what appeared to be a  bright point of light is really a fuzzy blur.”  

On the other hand, Evans recently said: “We are at a stage where the path of interest-rate increases seems  as clear as you can write up.” 

I agree with Williams that guidance from estimates of the neutral rate was more clear when rates were seen to be very far below estimates of the neutral rate. The precision of those estimates didn’t matter as much at that point. But the importance of an estimate of neutral becomes much greater as you get closer to it. And that’s where we are today. 

So what should FOMC participants do? Fly blind? Be informed by the data? It will take a lot of data to conclude that the neutral rate is different from estimates today, short-run or long-run. So FOMC  participants are left with using their estimates as a guidepost, recognizing the uncertainty. Given the importance most participants attach to removing accommodation, they appear to be committed to using their estimates of neutral (see the dots) in doing that. That seems clear. 

But once there, given the uncertainty about the neutral rate, there appears to be more angst about what to do: stop, pause, or continue. At that point, the incoming data and evolving forecast take center stage. Let the data inform your judgment. If the data are stronger than expected, some will say that the data and evolving forecast call for continuing to raise rates into restrictive territory. Others may see the strength of the economy as confirming that the funds rate is still short of neutral. Perhaps both will agree on an appropriate rate path but from different perspectives. 

Implications for the Path of the Funds Rate? Perhaps None. 

When the economy cools, there will be neither tailwinds nor headwinds, and the distinction between a short-run r-star and long-run r-star will presumably disappear again, at least for a while. Nevertheless, I will continue to monitor communications from participants, now with a particular focus on two new members of the troika,  President Williams, of Laubach and Williams fame, and Vice Chair Clarida, whom I expect will emerge as an intellectual leader on the Committee.  

No Change in Our Call 

Our call remains unchanged–hikes every other meeting through September 2019–to 25 basis points above participants’ current median estimate of the long-run neutral rate. This call is based on our forecast and consistent with participants’ macro projections of what the economy and forecast will look like in the second half of 2019. If their macro projections are on the mark, the Committee ultimately will be reluctant to continue to hike rates, given the sharp slowing in growth, the sharp slowdown in job gains, and, by 2020, an increase in the unemployment rate. Still, for now, our rate projections are only slightly lower than the median. It’s really more a question now of the logic underpinning their projected rate path. 

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