A major shift seems to be coming to the Federal Reserve.
Over the last few days a number of current and former Fed officials have spoken about their views on the economy, the future of interest rates, and possible ways to tweak their communication strategy.
In a report early Wednesday, CNBC’s Fed whisperer Steve Liesman characterised this as a “mini revolt” now facing Fed Chair Janet Yellen.
This report was followed by St. Louis Fed president James Bullard’s epic interview on Bloomberg Wednesday morning with Tom Keene and Michael McKee.
And what’s clear from Bullard’s comments is that the future of Fed policy seems more and more likely to be grounded in something new and radical than anything like the past.
The simplest way to summarize what the Fed has tried to do since the recession is keep interest rates low to help reduce unemployment and bring inflation up to 2% per year.
After achieving these goals the Fed would, in theory, be able to raise interest rates back to something “normal” — call this rate 3% or 4% or something in that range.
Of course many will be quick to note that with seven-plus years of interest rates at or near 0% — and rates in Japan in Europe actually dipping below this level now — central bank orthodoxies have already been upended.
And this is true.
But so much of the discussion around Fed policy now assumes that we’re moving back towards what Fed officials would call “normalized” policy with rates, again, near 3% or 4%. This might, however, turn out to simply be stone-age thinking in a radical new era for economics.
The early headlines out of Bullard’s interview reflected his view that perhaps the “dot plot” — which gives an overview of where Fed officials think its benchmark interest rate should be at some point in the future, not where it will likely be — is not accomplishing what it’s supposed to.
I’m sympathetic to this view, given that something as inscrutable as a chart with some dots scattered on it has gotten excessive attention from the market as the Fed’s forecast for future rate increases when this is not the plot’s function.
The point is, again, to reflect, given current conditions, where Fed officials think interest rates should be. In this way it’s more of an academic argument than a market forecast.
But the biggest thing said by Bullard on Wednesday was outlining the view that perhaps we’re already in a future of central banking where the obsession over when and where interest rates are heading can be done away with.
The “permazero” idea broadly says that the Fed’s nominal policy rate can be set at zero indefinitely because in a neo-Fisherian model of interest rates nominal rates are made up of two parts: real rates and inflation expectations.
Here’s Bullard from a November 2015 speech giving something like a plain-English explanation of what that means:
The Fisher equation states that the nominal interest rate can be decomposed into a real interest rate component and an expected inflation component. If we view the real interest rate as determined by supply and demand conditions in the private sector, then a permanent nominal interest rate peg would also pin down the long‐run rate of inflation. The Fisher equation implies, among other things, that the monetary authority cannot choose the long‐run value of the nominal policy interest rate separately from the long‐run value of inflation.
And so if the current low-interest-rate regime has anchored inflation expectations at something like the Fed’s preferred level near 2%, then our modern “interest rate peg” is actually the optimal policy.
(Hence concerns about inflation expectations becoming “unanchored,” which indicates policy that is no longer on a track to meet its inflation goals.)
In a sense, then, the idea of a “permazero” rate has begun to prove its efficacy.
On Wednesday, however, Keene challenged Bullard on the overall viability of this idea of a “permazero rate.”
Here’s the exchange (transcript via Bloomberg, emphasis mine):
KEENE: The permazero for too many of the people that follow Bloomberg Surveillance, they follow Michael McKee and me, and we get blistering emails, as I’m sure you do, from people that are not the elites. They don’t have your education or Mike’s and my zip code and that. I want you to speak now to the people in the St. Louis district who go, I’ll give you a permazero. It’s been my income for ten years. Where does the economic growth fund come from? And you’re the guy in your district that’s seen the manufacturing drift away, that chronic sense of permazero for America. Where do we get the growth?
BULLARD: The central bank cannot drive the growth process. Here’s what monetary policy is: There’s a business cycle and if you run a good monetary policy, there’s still a business cycle but it’s not quite as big as the previous business cycle. So that’s what monetary policy is. The growth rate is driven by long run factors in technology and human capital and what the U.S. needs is a better medium term growth strategy and you need everyone to get on board with that growth strategy. That’s what you need. The central bank cannot do that.
And so here Bullard is saying that look, there are certain assumptions about where monetary policy fits into the economy and business cycle and we might need to re-think all of those. I expect this sort of discussion to continue more forcefully in the coming months and years.
In a speech last Friday, Bullard outlined the “macroeconomic equilibrium” seen from 1984-2007.
Returning to this period — and the corresponding interest rate policies put in place during this time — is seen a desirable because we had long economic expansions, shallow recessions, and monetary policy that was understood by policymakers and financial markets.
But what if everything has changed?
In the wake of the Federal Reserve’s decision to keep interest rates at 0.25%-0.50% — and the market’s interpretation that we’re going to see, at most, two more rate hikes this year while inflation is picking up and the unemployment rate remains low — it seems that it has.
In a way, the economic data implies the Fed has met its goals and can, in earnest, begin pushing policy back towards something “normal. And so there seems, then, to be a disconnect brewing not just between the Fed, the markets, and the data, but within the Fed itself.
Again, Fed officials are out jawboning on how April’s meeting is “live,” implying there’s a chance interest rates could be increased. Markets think this is a fantasy.
And if the Fed has been backed into certain corners by the market’s pricing — you can’t raise rates, say, four times in six months against markets that have priced in four hikes over the next three years without getting some major shocks that could, in a nightmare scenario, ripple into the broader economy — then it’s certainly worth re-thinking what we’re really doing, what we’re trying to accomplish, and how we’re talking about it.
This is where Bullard is taking the conversation.