On Tuesday, Fed Governor Lael Brainard downplayed past talk of numerous rate hikes from the federal reserve and suggested that he Fed may “not have much more” to do in terms of rate hikes. ”In light of recent policy moves, I consider normalization of the federal funds rate to be well under way,” Brainard said.
Today, speaking before Congress, Janet Yellen built upon Brainard’s earlier comments, but simultaneously suggested that there will be ”gradual rate hikes” over “the next few years,” and hinting that many more rate hikes won’t be necessary because ”the neutral rate is low by historical standards.”
Markets took this to mean — probably correctly — that the Fed is moving in a more dovish direction.
The “Neutral Rate” Canard
Note that both announcements are based on the idea that the “neutral rate” is unusually low, so while a target rate of 1.5 percent may seem quite low by historical standards, it’s not really low. It is near the neutral rate — also known as the “natural rate.”
In other words, the “natural rate” has fallen below where it was in the past, so now, the interest rates we saw in the days of yore — those around 3 per cent or 5 percent — would today be much too high.
Bloomberg explained a bit more of the Fed’s logic here last year:
When Fed Chair Janet Yellen wants to explain why the Fed is keeping rates so low, she cites the natural rate. At the press conference following the FOMC’s June meeting, she said the neutral interest rate—which is essentially synonymous with the natural rate—“is quite depressed by historical standards.” She added: “I think all of us are involved in a process of constantly reevaluating where is that neutral rate going.”
Politically speaking, identifying this “natural rate” as being very low allows the Fed to create the perception that its very-low target rates aren’t really all that stimulative at all. They’re practically neutral! Just look at the natural rate, they’ll tell us.
The problem however, is that all good economic theory tells us that the Fed has no idea what the natural rate actually is. Earlier this year, Mark Spitznagel explained:
How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short-term interest rates (and there hasn’t been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.
Joseph Salerno explains this in even further detail in his article “The Fed and Bernanke Are Wrong About the Natural Interest Rate.”
All this talk about the natural/neutral interest rate thus provides political cover for the Fed, and allows the FOMC to claim that they’re using economic science in determining the “correct” target rate. In truth, the Fed has no idea what the natural rate is but is really just proceeding with great caution because the Fed’s leadership knows that allowing interest rates to increase beyond the current low levels would upset the fragile economy.
The Fed’s Balance Sheet
Thus, the question of the target rate remains constantly in flux, just as the Fed would like to have it.
Equally amorphous is the question of reducing the Fed’s balance sheet. This reduction, according to both Brainard and Yellen, will come “soon” (whatever that means). One thing we know for sure: it will take a while to implement:
Ms. Yellen told the House Financial Services Committee that unwinding a $4.5 trillion-plus balance sheet that includes $2.5 trillion in Treasuries and the rest in mortgage-backed securities will probably take until 2022 before it shrinks to pre-crisis levels. Fed officials have not decided yet on longer-term policy framework that will affect the size of reserves, she said.
This assumes, of course, there is no worsening in the economy between now and 2022, which is a tall order, to say the least.
Moreover, what are the details of how this balance-sheet wind-down will occur? It’s a great mystery. Also mysterious is why, in an age of massive home price inflation, the Fed still isn’t unloading those mortgage-backed securities.
All in all, there’s extremely little to see here in Yellen’s testimony. It’s the usual routine: the economy is experiencing “moderate” growth. We’ll raise rates — but not too much! We’ll wind down the balance sheet “soon.”
Meanwhile, the Fed continues to invent new explanations of why it needs to remain accommodative. The totally arbitrary 2-percent inflation target continues to serve as a justification for continued low rates. And, more recently, the “natural rate” explanation is starting to serve as a convenient excuse as well.
