Download The FRB St Louis New Economic Narrative and Negative Rates

The FRB St Louis New
Economic Narrative and
Negative Rates
Christopher Waller
Executive Vice President and Director
of Research
Federal Reserve Bank of St. Louis
Rutgers University
October 6th, 2016
Any opinions expressed here are my own and do not necessarily reflect those of the Federal Open Market Committee participants.
The U.S. Economy Recently
The U.S. economy has been in an expansion for more than
7 years.
However, this post-Great Recession expansion has been
characterized by relatively low growth and inflation,
although unemployment has fallen to roughly the level
believed to be its natural rate.
The U.S. Economy Recently
Particularly, average annualized GDP growth during this
time has been 2.1%.
Inflation, as measured by the price index for personal
consumption expenditures, has averaged 1.6%, which is
notably lower than the Federal Reserve target of 2%.
The U.S. Economy Recently
Index, Beginning of Each Recession=100
Post-Recession Real GDP Growth Has Been Much Lower This Time
145
135
125
1981-1982 Recession
115
2007-2009 Recession
105
95
0
5
10
15
20
Quarters Since Beginning of Recession
Source: Bureau of Economic Analysis/FRED
25
30
35
Expectations for the Future
Economic Projections of FOMC Meeting Participants
Median of September 2016 Projections
Variable
Real GDP Growth
Unemployment Rate
PCE Inflation
Core PCE Inflation
Federal Funds Rate
2016
1.8
4.8
1.3
1.7
0.6
2017
2.0
4.6
1.9
1.8
1.1
2018
2.0
4.5
2.0
2.0
1.9
Longer Run
1.8
4.8
2.0
2.9
The St. Louis Narrative
The St. Louis Fed has recently adopted a unique view of
the U.S. economy and its future path.
This view has largely been influenced by the way the
economy has behaved during the current expansion.
Unlike the forecasts provided by the FOMC participants,
this view is not conducive to the belief that there are longrun values for key economic variables.
Our Previous Narrative
Like most forecasters, we assumed a steady convergence to
our long-run projections of key economic variables.
But over the short run, we thought that there would be a
burst of above-trend growth that would continue to drive
the unemployment rate below its long-run value.
We also thought that the combination of stronger growth
and very easy policy would cause an overshooting of
inflation (temporarily above the 2% target).
Old Forecast
GDP growth
U
π
5.8%
3%
2%
t
Time
Our Previous Narrative
The forecasted overshooting was the main reason we
pushed for raising interest rates over the last year.
Rate changes affect the economy with a lag so we felt we
needed to get ahead of the curve.
We also felt that short-term real interest rates would move
up, which would mean we also had to raise the nominal
interest rate.
Our New Narrative
The economy can shift between “states” (think sunny and
cloudy), depending on the fundamentals of the economy.
States are generally viewed as persistent, and optimal
monetary policy varies across these states.
There is not a unique state of the world that the economy
will converge to.
We call these different states regimes.
Our New Narrative
The economy can settle down into a regime that can persist
for several years.
The economy’s growth path during these regimes depends
crucially on labor productivity growth (output per hour).
Labor productivity growth seems to exhibit regime
switching from high to low and back again. It also appears
to be very persistent.
Labor Productivity Growth
Labor Productivity Regimes
Year-Over-Year Percent Change in Real Nonfarm Business Output per Worker Hour
7
Q1:1996-Q4:2004 Growth Rate: 3.1%
Q2:1961-Q3:1973 Growth Rate: 3.1%
5
3
1
1960
-1
1965
1970
1975
-3
Source: Bureau of Labor Statistics/FRED
1980
1985
1990
1995
2000
2005
2010
2015
Q4:1973-Q3:1995 Growth Rate: 1.5%
Q1:2005-Q2:2016 Growth Rate: 1.3%
An Illustration – Old view
Productivity
growth
+ shock
3%
- shock
t
Time
An Illustration – New view
Productivity
growth
3%
1.5%
t
Time
Key Points
Shocks bounce the economy around the regime growth rate
and policy responds as usual within a regime but can differ
across regimes.
When the economy is close to the regime averages in terms
of GDP growth, inflation and unemployment (all “gaps”
are closed), then interest rate policy should be “neutral”.
This produces a very simple forecast: More of the same.
Two Other Fundamental Factors
Labor productivity growth is highly volatile and
recognizing shifts to new regimes is often difficult.
There are two other fundamental factors that we need to
look at to assess the current regime’s persistent low
growth.
These are: (1) the short-term real interest rate on safe liquid
government debt; and (2) the risk of recession.
Fundamental Factor #1: r-dagger
r-dagger (r†) is the real rate of return on short-term
government debt (r = i – πe)
It is important to distinguish r† from another key real
interest: The real rate of return on capital (rK).
Since reserves are close substitutes for short-term
government debt (not plants and equipment), we do not use
rK for setting our policy rate.
r-dagger Appears to be Abnormally Low
The Real Return to Capital Hasn't Fallen with r-Dagger
Percent Per Annum
19
14
U.S. Real Return to Capital (Pretax)
9
4
World r-Dagger
-1
1985
1988
1991
1994
Sources: Ravikumar, et. al; King & Low
1997
2000
2003
2006
2009
2012
2015
Why is r-dagger (r†) Abnormally Low?
One hypothesis is that there is a large liquidity premium on
safe liquid government debt that has made r† is abnormally
low -- in fact it’s negative!
We argue that there has been a large increase in the
demand for government debt because of (1) global savings
glut, (2) demographics, (3) regulatory changes and (4) geopolitical uncertainty.
Fundamental Factor #2: Recession Risks
Recessions cause real GDP growth to go negative – they
can happen in either regime. They are low probability
events, but it’s more likely to happen in the low-growth
rate regime.
When recession risk increases, firms and households can
reduce their expectations for future growth and incomes.
This leads to lower investment and spending.
This development becomes a risk to the forecast.
Recession Risks Are Very Low
A Prominent Recession Probability Model Remains Relatively Flat
1=100% Chance of Recession
1
0.8
0.6
0.4
0.2
0
2005
2006
2007
2008
Source: Piger and Chauvet/FRED
2009
2010
2011
2012
2013
2014
2015
2016
Last Observation: June 2016
The Last Piece of the Narrative
We believe that the economy’s regime is characterized by:
 Low productivity growth;
 Low real rate interest rates on safe government debt (r†);
 Continued low economic growth (no recession);
 Variables near targets (gaps are zero).
The St. Louis Fed’s Economic Projections
The St. Louis Fed's Projection for Real GDP Growth, 2016‐2018
The St. Louis Fed's Projection for the Unemployment Rate, 2016‐2018
The St. Louis Fed's Projection for the Inflation Rate, 2016‐2018
Percent changes at compounded annual rates
Percent of civilian labor force
Percent changes at compounded annual rates
6.0
3.0
3.0
5.0
2.1
2.0
2.0
4.9
4.7
2.0
2.0
2.0
4.0
1.0
3.0
0.0
2.0
1.0
Actual, 2009‐16 2016‐2018 (P)
Source: Author's calculations using BEA data.
Actual, August
2016
Source: Bureau of Labor Statistics.
2016‐2018 (P)
Actual, Q2 2016 2016‐2018 (P)
Source: BEA.
The Last Piece of the Narrative
This is where we bring in the policy path.
With the gaps closed, no overshooting expected and real
rates on short-term government debt expected to stay
negative for the next couple of years, we see no reason to
forecast a rise in the policy rate.
Our mandate is not to raise rates for the sake of raising
rates.
The St. Louis Fed’s Policy Rate Projections
FOMC Participants’ Assessments of Appropriate Monetary Policy
St. Louis Fed
Projections
NA
Why 63 Basis Points?
With the gaps closed, r† ≈ -1.4% and π ≈ πe ≈ 2% the Fed’s
neutral policy rate is about 0.6%. (a range for the fed funds
rate of 0.5% to 0.75%)
We will be at that value in one more move.
The gaps are likely to stay closed or nearly so for the next
2.5 years.
So no more hikes are needed unless shocks hit us.
A Cause for Concern
So, due to a low r-dagger, the St. Louis Fed and other
forecasters expect the federal funds rate to remain
relatively low.
The problem with a lower federal funds rate is that there is
less room to stimulate the economy during a recession by
dropping the rate.
The question of whether a negative federal funds rate is a
viable option arises.
Negative Rate Rationale
The idea behind a negative interest rate policy (NIRP) is
similar to the idea behind any interest rate drop by a central
bank.
Lower interest rates should drive up investment as
borrowing costs fall, and drive up consumption as saving
becomes less appealing.
The resultant economic expansion will hopefully increase
inflation.
Negative Rate Rationale
Another consequence of a lower interest rate is a
depreciation of the exchange rate, which expands exports
and GDP.
This consequence explains the actions of some countries
currently under NIRP.
In particular, appreciation of the Danish kroner after the
Swiss and ECB NIRP enactments led Denmark to go
negative.
Negative Rate Rationale
NIRP Used to Stop Danish Kroner Appreciation
Kroners/Euro, ↓=Appreciation
7.50
6/5/14: ECB
announces NIRP
1/20/15: Denmark begins
series of rate cuts
12/18/14: Swiss
announce NIRP
7.45
7.40
Jan-2014
May-2014
Sep-2014
Sources: Danmarks Nationalbank/Haver
Jan-2015
May-2015
Sep-2015
NIRP Implementation
Implementing NIRP is not as simple as implementing
ZIRP.
Negative rates bring about a new set of concerning
incentives.
Banks are incentivized to hold cash instead of reserves if
rates go too low, which would mean no credit expansion.
If banks pass through too much of the “tax” to customers,
the customers may start hoarding cash.
NIRP Implementation
But negative rates hurt bank profitability if part of this
“tax” cannot be passed through to customers.
So banks have a few options: absorb some of the costs, hold
more cash, pass negative rates on to depositors, and/or
increase interest rates on the funds they lend.
None of those options sound very “stimulative” for the
economy.
NIRP Implementation
Mortgage Rates Rose Against Negative Policy Rates in 2015
Percent
3.50
3.00
6/5/14: ECB
Announces
Negative Rates
12/18/14: Swiss
Announce
Negative Rates
2.50
Germany: Interest Rate on
New >10 Year Mortgages
2.00
1.50
1.00
Jan-2014
May-2014
Sep-2014
Jan-2015
May-2015
Sources: ECB/Haver Analytics & Swiss National Bank
Switzerland: Interest Rate on New
10-15 Year Fixed Rate Mortgages
Sep-2015
Jan-2016
May-2016
NIRP Implementation
Negative Rates Among the Reasons for Bank Stock Declines
Indices
255
235
215
6/5/2014: ECB
Announces
Negative Rates
Japan TOPIX
Banks Index
1/29/2016: BOJ
12/3/2015: ECB Announces
Negative Rates
Rate Cut
3/10/2015: ECB
Announced
Rate Cut
Announced
195
175
155
135
115
95
Euro STOXX
Banks Index
75
Jan-2014
Jun-2014
Nov-2014
Apr-2015
Sep-2015
Sources: STOXX and Tokyo Stock Exchange/Bloomberg Financial
Feb-2016
Jul-2016
Neo-Fisherism and Inflation
The theory behind NIRP may be flawed.
Standard orthodox theory says that lower interest rates
should increase inflation due to economic expansion, NeoFisherites argue the opposite.
The latter group focuses on the Fisher Equation:
Neo-Fisherism and Inflation
i = r + πe
r = real interest rate
i = nominal interest rate
πe = expected inflation
If i is held at zero and r rises, then π and πe fall.
Thus, after a long period of ZIRP, i must be increased
to raise inflation, not the other way around.
NIRP Consequences
So which theory is prevailing?
Japan has had i = 0 for 20 years, yet faces deflation. US
has been at zero for 7 years and we can’t hit 2%. ECB has
been at zero for several years and faces deflation.
Why would things be any different with negative rates?
Nevertheless, how has NIRP affected GDP and inflation?
NIRP Consequences
EU's 2016 Growth and Inflation Concerns Have Increased Under NIRP
Projected Annual Percent Change for 2016
2 6/15/14: ECB
announces NIRP
Real GDP
HICP Inflation
1.6
1.2
0.8
0.4
0
Mar-14
Source: ECB
Sep-14
Mar-15
Sep-15
Mar-16
Sep-16
Takeaways
The U.S. economy is in a relatively long expansion, but
one characterized by low growth.
The St. Louis Fed view is that the economy is in a lowgrowth regime.
With a low real interest rate on government debt, a
recession opens the door for a negative fed funds debate.
Takeaways
But negative interest rates are a tax on the banking sector
that has to be borne by someone. Taxes are never
“stimulative”.
ZIRP has not caused inflation to rise or GDP to grow
rapidly.
Why would things be any different with negative rates?
Federal Reserve Bank of St. Louis
stlouisfed.org
Federal Reserve Economic Data
(FRED)
research.stlouisfed.org/fred2/