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Why the Fed has a rate-setting problem

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Many people think they know how interest rates get set: The Federal Reserve does it.

But that's not quite how it works. The interest rate that's consistent with stable inflation and full employment is known as the natural, or equilibrium, rate of interest in the economics literature. And it's determined by economic conditions that the Fed must take into account when formulating its plans for monetary policy.

If the natural rate of interest changes, the Fed must alter the target rate of interest rate accordingly, if it wants to maintain a particular monetary policy stance.

To determine whether the central bank's monetary policy is expansionary or contractionary, the Fed's target interest rate -- the federal funds rate -- must be compared to natural rate of interest. Let's say prior to a recession, the federal funds rate and the short-run natural rate of interest are both 6 percent, representing a neutral policy for the economy. But then a recession lowers the short-run natural rate to 3 percent, so a cut in the fed funds rate to 3.5 percent would actually be a contractionary policy stance.

Even though the Fed has cut its target rate by 2.5 percentage points, the fact that it's still higher than the natural rate would tend to push the economy further into recession rather than offset the downward plunge. Thus, in a recession, easing of monetary policy requires the Fed to lower its target interest rate faster than the natural rate of interest falls.

The natural rate of interest for the economy depends on several factors that could push it lower in the future:

  • First, population growth has fallen from 1.1 percent to 0.7 percent since 2000, and lower population growth tends to push down the natural rate rate.
  • Second, productivity growth has been falling, which also exerts downward pressure on the natural rate.
  • Third, if the economy is entering a period of secular stagnation -- a time when the amount of investment is less than the amount of saving due to insufficient demand in the economy (as Larry Summers and others have warned may be the case now) -- the excess saving will also tend to reduce the natural rate of interest.
  • Fourth, slow and uncertain economic growth in other countries causes an increase in the demand for U.S. financial assets, and this results in an increase in the price of financial assets and a fall in their yields.

If these factors result in the natural rate of interest being lower in the future than it has been in the past, as many analysts expect, it raises important implications for the conduct of monetary policy.

Federal Reserve officials have discussed their desire for interest rate normalization, but what if rates stay as low as they've been in recent years due to the influence of these factors rather than increasing once the economy hits full employment?

Suppose, for example, the natural rate of interest remains near zero, as it has been in recent years. In that case, attempts to normalize the Fed's target rate of interest through rate increases would push the target rate above the natural rate of interest and create contractionary pressure in the economy. For this reason, the Fed's desire to get interest rates back to levels of the past could be a big mistake.

The natural rate of interest

A new normal with low interests rates will also mean the Fed has to consider changes in the way it conducts monetary policy. Traditionally, it has used cuts in interest rates as its main recession-fighting tool. But if interest rates begin at a relatively low level, the amount of room the Fed has to cut rates will be limited. Thus, even in moderate recessions, the Fed could run into "zero lower bound" problems of the type it encountered in the Great Recession.

One option for getting around this problem is to raise the inflation target, a change in policy that would have the effect of raising the baseline interest rate in normal times. This would give the Fed more room to cut rates if the economy encounters problems, but such a policy could encounter significant political opposition in Congress and lead to restraints on the central bank's independence, something the Fed wouldn't want to risk.

Another option is to consider negative interest rates on reserves held by banks. As former Federal Reserve Chair Ben Bernanke explained, "In practice this means that, instead of receiving interest on the reserves they hold with the central bank, banks are charged a fee on reserves above a threshold. The expectation is that, to avoid the fee, banks will shift to other short-term assets, which drives down the yields on those assets as well, possibly to negative levels."

Other central banks have implemented such a policy, notably the Bank of Japan and the European Central bank, so the Fed would have the advantage of learning from their policy experiments.

A third option is the use of "helicopter money," which involves a change in fiscal policy such as increased government spending or a tax cut financed by printing money rather than issuing government bonds.

Theoretically, this is a powerful tool for stimulating the economy. However, it would require coordination between monetary and fiscal policymakers, and the difficulties associated with getting Congress to overcome political gridlock and endorse a particular policy would likely render this approach unreliable.

During the Great Recession, the Fed turned to quantitative easing after its traditional policy tool, cuts in the federal funds rate, was no longer available because it had hit the zero lower bound. Quantitative easing will be available in the future if the Fed runs into similar problems, as it very well could if the natural rate of interest stays low. But while quantitative easing provides some boost to the economy, it's not as powerful as cuts in the interest rate.

So the Fed would be wise to thoroughly investigate those other options and have a specific plan of attack ready when it's needed.

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