While the Federal Reserve’s decision on Wednesday not to raise the key interest rate may have been a bit predictable, there was at least one oddity that came out of the meeting.
It occurred in the Fed’s so-called “dot plot” of each members forecasts where they believe the federal funds interest rate will be over the next three years. Most of the dots got more dovish, but one member was running radically against consensus.
While every other member projected at least one rate hike this year and gradual hikes over the next two years, these particular dots showed that a participant expected just one rate hike in 2016 and none in 2017 or 2018. Then, in the longer-run section that projects interest rates further out than 3 years, one dot simply disappeared.
Due to the anonymous nature of the plot, there was no real way to know which of the members was responsible. In fact, it could have been multiple participants responsible for each of the low dots and the disappearing dot.
However, a new paper from one of the branches of the Fed reveals the man behind the mysterious dot: James Bullard of the St. Louis Fed.
According to the paper from the St. Louis Fed, the branch has adjusted its model of projecting the economic forecast. In this new method, the St. Louis Fed will only project two and a half years out, thus they do not have data for the longer-run dot.
“Consistent with the regime-based concept, the new approach does not contain projected long-run values for macroeconomic variables or for the policy rate,” said Bullard in the paper. “That is, the forecast simply stops at 2 ½ years.”
In the paper, Bullard said the St. Louis Fed is switching to a “regime-based” approach to forecasting instead of going for a particular policy goal.
The hallmark of the new narrative is to think of medium- and longer-term macroeconomic outcomes in terms of regimes. The concept of a single, long-run steady state to which the economy is converging is abandoned, and is replaced by a set of possible regimes that the economy may visit. Regimes are generally viewed as persistent, and optimal monetary policy is viewed as regime dependent. Switches between regimes are viewed as not forecastable.
In this new regime, argues Bullard, the unemployment rate will settle at 4.7%, core PCE inflation will hit 2%, and GDP growth will remain roughly around 2%. The interest rate, however, will be 0.63%.
The idea Bullard is advocating for is that to achieve the “steady state” of the economy that the Fed desires, 2% inflation and full employment, interest rates may simply have to be lower. Instead of focusing on a long-run interest rate where the Fed thinks it should be, the central bank should react to its goals and the state of the economy.
Currently, in this projection, the interest rate needed to achieve the goals of the Fed is at the 0.63% level. And while interest rates and growth may not be as nominally high as previous cycles, Bullard said, it is appropriate given the factors governing the economy at this time.
This is not a new idea for Bullard, who has argued that “perma-zero” interest rates could be an effective policy method as long as the economic goals of the Fed are met. Additionally, this is the same member who wants to get rid of the dot plot.
And there it is, mystery solved.