Sunday, June 03, 2018

Is There A Neutral Interest Rate? If So, How Much Is it?

See Fed Minutes Signal Rate Increase in June: May meeting minutes say ‘it would likely soon be appropriate’ for another rate rise by Nick Timiraos of The WSJ. Excerpts:
"The Fed held its benchmark federal-funds rate steady at the May meeting in a range between 1.5% and 1.75%, but it looked ahead to future increases that might leave policy at a neutral level that neither spurs nor slows growth."

"The Fed’s postmeeting statement at the May meeting caught some attention because officials added a second reference to their “symmetric” 2% inflation target, meaning they won’t necessarily accelerate interest rate increases once inflation runs at or slightly above 2%."

Some officials at the May meeting said a temporary period in which inflation rises modestly above 2% “would be consistent with the committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.”

At the time of the May meeting, the unemployment rate had held steady since October at 4.1%. A report released after the meeting showed the rate fell to 3.9% in April.

Most officials still believe in a framework that sees an inverse relationship between unemployment and inflation (the is is the Phillips Curve). If the unemployment rate drops faster, officials likely will be more attuned to the potential for acceleration in inflation.

The minutes show officials are still unsure over the degree to which lower unemployment will fuel faster wage increases or firmer price pressures"

"San Francisco Fed President John Williams said last week he still estimates the current neutral fed-funds rate to be 2.5%. Officials’ March projections show a median expectation that the fed-funds rate would settle over the long-run at around 2.9%—an approximation of neutral.

Estimates of the neutral rate matter because a consensus appears to be forming among Fed officials that they should stay on their current “gradual” path of raising rates by a quarter percentage point at roughly every other meeting until they reach neutral. The bigger debate is likely to be over what to do after they get there."

AD and SRAS help explain what is going on. As AD increases or shifts to the right, prices rise. But the increases get bigger. Q or GDP increases, which lowers unemployment, but less each time. That tells the same story as the Phillips curve. But, what if supply shifts to the right? (which I don't show). If SRAS shifts more to the right than AD, then the rise in prices might be slight (and inflation could be less than what it was in the past) while the increases in Q can be large and the unemployment rate falls. That is the opposite of the Phillips Curve. So the Phillips Curve has to assume a fixed SRAS. Maybe a neutral interest rate keeps AD right at QF, the level of GDP that gives us the lowest rate of unemployment with inflation no higher than a set target. This is full-employment.

Related posts:

Is The Phillips Curve Dead In Japan? Maybe not

Is The Phillips Curve Not Holding Up Well Beacuse The Service And Goods Sectors Are Behaving Differently?

Has the Fed Flattened the Phillips Curve?

Nobody knows what the natural rate of unemployment is today

More on the natural rate of unemployment

How Central Banks Differ In Their Methods Of Calculating Inflation.

Fed Officials Disagree On Threat Of Inflation (from 2009)

Fed Chair Janet Yellen: "there remains considerable slack in the economy" (from 2014) 

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