162308 fed lower for longer

US Watch

Group Economics Macro & Financial Markets Research

23 August 2016

Fed: lower for longer?

Maritza Cabezas Senior Economist Tel: +31 20 343 5618 maritza.cabezas@nl.abnamro.com

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Fed policymakers’ recent discussions show that they continue to be split

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Low US GDP growth and inflation have increased Fed’s concerns

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However, a few continue to support a rate hike this year…

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…while others are in favour of a “rethink of monetary policy”…

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…and more fiscal support

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We don’t expect any changes in the monetary framework any time soon

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We continue to expect the Fed to remain on hold until early next year and to hike three times in total in 2017

The communication of FOMC members in the past few days has left Fed watchers a bit confused about the monetary policy outlook. Although the federal funds rate is forecast by the FOMC to settle at 3% over the next few years, which is already low for historical standards, the forward guidance of some officials seems to suggest the federal fund rate could be even “lower for longer”. Indeed the more cautious FOMC members consider that the structure of the US economy has changed and suggest that it’s time to consider a “rethink” of monetary policy. But Fed officials remain split. A few of the more hawkish officials suggest that there is still a possibility of hiking rates as soon as September. We continue to expect the Fed to remain on hold this year and to hike three times next year, reaching 1.25% at the end of 2017. This note discusses the recent communication of Fed officials.

FOMC members remain split Since Fed policymakers met in July, a brighter picture of the US labour market has emerged. However, other economic indicators are somewhat mixed. For instance, reaching the inflation goal of 2% has become elusive, while economic growth in the first half of the year has been weak. The more recent minutes showed that Fed officials are not yet confident that inflation will rise to meet the 2% goal after running below the target for many years.

Insights.abnamro.nl/en

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US Watch - Fed: lower for longer? ? - 23 Augus st 2016

Diisappointing GDP growth and inflation n prompt the Fed to rethink policy %

2 2.0 6

US GDP growth % yoy

5

Core PCE price index, % yoy

1.6

1 1.5

4 3 2

1 1.0

1.2

1 0 0.5

0 -1 -2

0 0.0 13

14

15

16

14

13

15

16

So ource: Thomson Reuters R Datastream m, ABN AMRO

eflected in divid ded views of Fe ed officials on tthe US econom my and on This uncertainty is re al funds rate. This T is one of th he main reasonns why membe ers have the path of the federa ed to keep theirr options open since the first rate hike. The more hawkish members, decide including Mester and d George, contiinue to insist th hat improvemennt in the US ec conomy will ually given the risks of waitingg too long. How wever, there prompt the Fed to raiise rates gradu have been b some cha anges in tone among a the dove es as well. New w York Fed Pre esident Dudley y, has suggeste ed last week th hat an interest rate increase ccould occur before the end of the year. Stanley F Fischer, the Vic ce-Chair of the e Fed’s Board oof Governors also pbeat assessme ent of the econ nomy. Though, in general, it seems s the deliverred a rather up doves who remain a majority, are in n favour of a “w wait and see appproach”. Their usness is relate ed to the impact that some ev vents are havinng on the US economy e cautiou olicy should ev and ho ow monetary po volve.

FOMC C policymake ers remain sp plit Hawks

Lacker, M Mester, Lockharrt, George ((v)

(v)

Dudley, K Kashkari, Kaplan (v)

Yellen, Fisscher, Rosengrren, Bullard, Taarullo, Evans, P Powell, William ms, Harker (v) ((v) (v)

(v)

( (v)

(v)

Brainard (v) D Doves V - votin ng member Source: ABN AMRO

p for m monetary poliicy…

New proposals Indeed d in the past few w days, a few Fed members are questioninng whether som mething has fundam mentally chang ged in the US economy e to sup pport an even llower natural ra ate of interes st or equilibrium m interest rate level. This is th he rate that is eexpected to pre evail when

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US Watch - Fed: lower for longer? ? - 23 Augus st 2016

the eco onomy is at fulll strength and the stance of monetary m policyy is neutral. Fe ed Reserve Bank of o San Franciscco President Williams W has suggested that ggiven slower tre end of produc ctivity and econ nomic growth, as well as eme erging markets seeking large reserves of safe as ssets and a mo ore general sav vings glut that the natural ratee of interest co ould be lower. For Williams th he new challen nge is to deliver stable inflatioon in a low neutral rate ms mentioned th hat this low neu utral rate enviro ronment has its s roots in the environment. William ar stagnation w where interest ra ates and inflation are persisteently low (Summers secula 2015)1. Williams prop poses that options should be examined for rraising the infla ation target above 2% or moving toward a new target pegged to nominal GD DP growth. This proposal o immediately shift s monetary policy, but to eevaluate the prros and is not a suggestion to cons. At A the same tim me Fed Preside ent Bullard, has mentioned thhat monetary policy could shift to o a new regime e in the future, given g the low trend GDP grow wth and expliciitly expres ssed his prefere ence to delay rate r hikes. ...have e not found su upport in the past p These proposals are not entirely ne ew. However, the opinions of policymakers have been more on o the cautiouss side. Chair Ja anet Yellen exp pressed in Sepptember 2015 that changes in the inflation target could ruin the central bank’s credibility beca cause it may be e seen as while in 2010 fo ormer Fed Cha air Bernanke suummarized the costs and opporttunistic. Meanw benefitts and mention ned that the cos sts were higher then, mainly aas a result of the increas sing uncertaintty that this could entail for risk k premiums in financial marke ets.

Howev ver, it is reason nable to consta antly reassess these t proposalls in light of changing economic developme ents. The meettings in Jackso on Hole which sstart 25 Augustt will likely serve as a a platform to o discuss these issues.

A case e for changing g the inflation n target Olivierr Blanchard in 2 2010, togetherr with two IMF colleagues c at thhat time, wrote e a paper in which they challenge ed the historica al case for low inflation. They suggested that during the global financial crisiss, allowing for higher h inflation would have maade the recess sion less deep. Higher average e inflation and thus higher intterest rates to sstart with, would have made it possible to ccut interest rate es more. The question is whetther policymak kers now should d aim for a high her inflation rate e in normal tim mes to increasee room for monetary policy.

Howev ver, they add th hat the problem m is that raising g the inflation taarget of 2% is not without risks. Higher H inflation n usually comes with more vo olatility or can reesult in widesp pread inflatio on indexation. T The credibility of o the central bank b can be puut at risk and inflation expecttations could ra apidly become unanchored. The T major objeection to mainta aining the inflatio on target is thatt the alternative e may be worse. Given a low w neutral rate an nd low inflatio on, real interestt may not be ab ble to fall sharp ply enough to sstimulate the ec conomy. On top of this with a high her inflation tarrget, central banks would havve less need for and other uncon nventional tools. quantittative easing a Fiscal stimulus bac ck on the agen nda At this point of the disscussion, there e are not really y path breakingg ideas. Howev ver, some propos sals that have b been shelved in the past years seem to be ggetting more support now, including fiscal policyy. Some Fed offficials think tha at stubbornly loow growth and inflation equire support outside the Fe ed’s control. Bo oard of Governoors members Fischer F and may re Powell have mention ned recently the e importance of o fiscal policy. V Vice-Chair Fischer 1

Summers, Lawre ence H. 2015. “D Demand Side Secular Stagnati on.” American Economic E Revie ew

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US Watch - Fed: lower for longer? ? - 23 Augus st 2016

mentio oned in the passt days that “the e key to boosting productivityy growth and th he long run potential for the econ nomy is more liikely to be foun nd in effective ffiscal policy and regulatory policie es”. This would include improv ved public infra astructure and better educatio on.

What are a others exp pecting from the t Fed? Investo or’s expectatio ons of a rate hik ke have been quite q volatile thhis year. In the beginning of the yea ar, federal fund ds future rates suggested tha at investors antticipated four ra ate increas ses, now they are anticipating g one rate hike e in the comingg year. Meanwh hile, in a recent survey of 56 e economists in which w we partic cipate, two-thirdds of economis sts are now forecasting a move in n December. Most M economistts have becom me more conserrvative, since they t initially forrecasted two ra ate hikes earlie er this year. In 22017, a third off the survey yed economistss expect a rate hike and a furrther 30 percennt said that the central bank would raise rates bettween three an nd five times ne ext year. We coontinue to expe ect the Fed to maintain rates on h hold until early y next year and to hike three ttimes next year, but there are risks that the path h of rate hikes could be even slower in 20177. We think tha at inflation remain ns too soft for a rate hike soon, while interna ational developpments are stilll uncertain.

Regard ding the longerr-run monetary y policy framew work of the Fedd, we think that the difference in views iss still too large for the Fed to make m any subsstantial change es to the work in the nea ar term. The de ebate on monetary policy will continue in the e Jackson framew Hole Symposium S thiss week and Ch hair Yellen’s speech will likelyy give some rele evant input on this s topic.

Fin nd out more abo out Group Eco onomics at: http ps://insights.a abnamro.nl/en n/

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