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April 29, 2005

Has Fed Policy Been Less Accommodating than is Widely Believed?

Institutional Economics discusses a paper by John H. Makin where Makin argues that the equilibrium real interest rate has fallen recently and because of this, monetary policy has not been as accommodating as is widely believed:
It is beginning to appear as though the current rate of 2.75 percent is at or above neutral. If so, that would be about a full percentage point below what many were guessing. ... A number of exogenous events have combined to produce what probably amounts to a reduction in the neutral real fed funds rate. … the price of oil in April 2005 is 50 percent higher than it was a year earlier. … the impact of oil prices on growth and inflation suggests that higher energy prices operate on the economy with a lag of about one year. … the global economy has slowed sharply over the past four to six weeks … The simultaneous slowdown of the economies of the United States, Europe, and Japan virtually guarantees a global economic slowdown. …China, the perennial wild card, has moved toward a less growth-oriented stance … The other problem plaguing the United States… is the persistence of inflation pressures already in the pipeline. ... Such a stagflationary environment pulls the central bank in two directions. The slowing economy says to stop raising interest rates while rising inflation says to continue raising them. … interest rate increases have been more than sufficient to slow growth. … The Federal Reserve … faces a difficult task. Higher energy prices will probably seep through and produce higher core inflation approaching a 2.5-percent rate by fall. If ... the real economy and markets fail to recover ... the Fed will need to give serious consideration to holding the fed funds rate around 3 percent and allowing a slowing global economy to ease the upward pressure on energy prices. That said, a sharp drop in stock prices or the housing market should not result in a Fed easing, since even more inflation pressures… from energy and resurgent asset markets, would only require a disruptive resumption of rate increases in the near future.
How has the real interest rate behaved in recent years? Let’s look at some data. Here is the federal funds rate minus the CPI less food and energy inflation rate, a measure of the ex-post real federal funds rate along with NBER dated contractions. The data are monthly and begin in 1957:
Click on Graph for a Larger and Clearer Version
Notice the evolution of the real rate since the beginning of the 1980’s. There is a consistent decline until around 1986 followed by a period of tightening. However, the period of tightening is brief and the real rate declines consistently until it hits zero around 1992. In 1992 the real rate begins rising and continues to rise until mid 1990’s where the increase flattens considerably. Then in the recession beginning in 2001 the real rate drops to near zero quickly and has remained at that level ever since. By this measure, the ex-post real rate is low by historical standards. It has only been this low once before since 1980, in 1992, and the low real rate is more persistent this time than in 1992. However, it has been this low prior to 1980 and it is interesting to note the similarity in the real rate movements in the mid 1970's to recent movements in the real rate. But the ex-post real rate is not what matters for policy or for economic decisions. The ex-post real rate is measured using actual rather than expected inflation and thus it fails to fully capture information about future economic conditions. For example, if the expected inflation rate is lower than the actual rate, then this measure of the ex-ante real rate, the variable we want to know about, will be too low. I believe that inflationary expectations are anchored. If so, then it is difficult to get much mileage out of arguments that separate actual from expected inflation in either direction in the near future. These data have made me question my past advocacy for increases in the federal funds rate. Could Makin be correct? Has the equilibrium real interest rate fallen, and if so is it enough to make policymakers think twice about an aggressive response to recent price data? Even after seeing these data I still believe that any noteworthy price pressure must be dealt with through appropriate monetary tightening.

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