For release on delivery
12:45 p.m. EDT
September 12, 2018
What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?
Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at the
Detroit Economic Club
Detroit, Michigan
September 12, 2018
It is a pleasure to be in Detroit. I started my career working here in the Motor
City, and I have followed the fortunes of this area with interest ever since. A few years
ago, I visited some of Detroit's neighborhoods with our local officials at a time when
damage from the crisis was still While challenges remain in many of the city's
pervasive.
neighborhoods, since that time the metropolitan area overall has seen signs of a rebound
in business activity and investment, and the unemployment rate has continued to trend
downward, recently falling to 4.3 percent.1
This is similar to the nation's economy more broadly. While challenges remain
for many, aggregate growth is strong, and the economy is meeting our full employment
and inflation objectives. Given the outlook, it comes as no surprise that the Federal Open
Market Committee (FOMC) has been gradually raising interest rates from crisis-era lows
and sees further gradual increases as likely to be appropriate in its most recent statement.2
Before discussing the outlook, it might be useful to first explore some concepts that are
important in informing the path of rates.
What Is the Neutral Rate of Interest?
In thinking about how we should set the federal funds rate, many policymakers
and economists find the concept of the neutral rate of interest to be a useful frame of
reference. So, what does the neutral rate mean? Intuitively, I think of the nominal
neutral interest rate as the level of the federal funds rate that keeps output growing around
its potential rate in an environment of full employment and stable inflation.3
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Focusing first on the "shorter-run" neutral rate, this does not stay fixed, but rather
fluctuates along with important changes in economic conditions. For instance, legislation
that increases the budget deficit through tax cuts and spending increases can be expected
to generate tailwinds to domestic demand and thus to push up the shorter-run neutral
interest rate. Heightened risk appetite among investors similarly can be expected to push
up the shorter-run neutral rate. Conversely, many of the forces that contributed to the
financial crisis--such as fear and uncertainty on the part of businesses and households--
can be expected to lower the neutral rate of interest, as can declines in foreign demand for
U.S. exports.
In many circumstances, monetary policy can help keep the economy on its
sustainable path at full employment by adjusting the policy rate to reflect movements in
the shorter-run neutral rate. In this context, the appropriate reference for assessing the
stance of monetary policy is the gap between the policy rate and the nominal shorter-run
neutral rate.
So far, I have been focusing on the shorter-run neutral rate of interest that is
responsive to headwinds or tailwinds to demand. The longer-run equilibrium rate is a
related concept. The underlying concept of the "longer run" generally refers to the output
growing at its longer-run trend, after transitory forces reflecting headwinds or tailwinds
have played out, in an environment of full employment and inflation running at the
FOMC objective.4
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The longer-run federal funds rate estimated by FOMC participants in their
Summary of Economic Projections (SEP) meets the definition of a longer-run
equilibrium rate of interest.5 It is worth highlighting that the longer-run federal funds
rate is the only neutral interest rate reported in the FOMC projections. But the shorter-
run neutral rate, rather than the longer-run federal funds rate, is the relevant benchmark
for assessing the near-term path of monetary policy in the presence of headwinds or
tailwinds.
Estimating the Neutral Rate of Interest
Similar to other equilibrium macroeconomic concepts such as potential gross
domestic product (GDP) and the natural rate of unemployment, the shorter- and longer-
run levels of the neutral rate are not directly observable, so they must be estimated or
inferred from the movements of variables that are observed, such as market interest rates,
inflation, the unemployment rate, and GDP.6 In recent years, considerable work has
derived estimates of the longer-run equilibrium rate, in some cases using statistical
techniques that can be thought of as capturing the highly persistent component of the
neutral rate. The central tendency of those estimates suggests that the longer-run trend
rate is in the range of 2.5 to 3.5 percent in nominal terms.7 This range lines up well with
the most recent median estimate of the longer-run federal funds rate in the FOMC SEP,
5
As defined in the FOMC SEP, "Longer-run projections represent each participant's assessment of the rate
to which each variable would be expected to converge under appropriate monetary policy and in the
absence of further shocks to the economy." See the most recent SEP, an addendum to the minutes of the
June 2018 FOMC meeting, available in a July 5, 2018, press release on the Board's website at
https://www.federalreserve.gov/newsevents/pressreleases/monetary20180705a.htm.
6
See Powell (2018).
7
See Kiley (2015); Johannsen and Mertens (2016); Holston, Laubach, and Williams (2017); Laubach and
Williams (2003) (current estimates available on the Federal Reserve Bank of New York's website at
https://www.newyorkfed.org/medialibrary/media/research/economists/williams/data/Laubach_Williams_cu
rrent_estimates.xlsx); Lewis and Vazquez-Grande (2017); and Lubik and Matthes (2015).
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which is just below 3 percent. By these estimates, the longer-run neutral rate has fallen
considerably from the estimated range in earlier decades of 4 to 5 percent.8
Turning to the shorter-run neutral rate, although the estimates are model
dependent and uncertain, we can make some general inferences about its recent evolution
that are largely independent of the details of specific models.9 Estimates suggest the
shorter-run neutral rate tends to be cyclical, falling in recessions and rising during
expansions, and our current expansion appears to be no exception.10
Last year, the unemployment rate returned to pre-crisis levels, which required real
interest rates that were below zero for nearly 10 years.11 This year, the unemployment
rate has fallen further, and job market gains have gathered strength, at the same time that
the federal funds rate has increased. This combination suggests that the short-run neutral
interest rate likely has also increased. If, instead, the neutral rate had remained constant
as the federal funds rate increased, we would have expected to see labor market gains
slow. That inference is consistent with the formal model estimates, which indicate that
the shorter-run neutral rate has gone up as the expansion has advanced. This is also
suggested by the observation that overall financial conditions, as measured by a variety of
indexes, have remained quite accommodative during a period when the federal funds rate
has been moving higher.
In the latest FOMC SEP median path, by the end of next year, the federal funds
rate is projected to rise to a level that exceeds the longer-run federal funds rate during a
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time when real GDP growth is projected to exceed its longer-run pace and unemployment
continues to fall. The shift from headwinds to tailwinds may be expected to push the
shorter-run neutral rate above its longer-run trend in the next year or two, just as it fell
below the longer-run equilibrium rate following the financial crisis. Notably, the sizable
fiscal stimulus in the pipeline is likely to continue to bolster the short-run neutral rate
over the next two years. The relatively rich level of current asset valuations relative to
historical levels is another factor that could push the short-run neutral rate above its
longer-run value. As was noted in the recent FOMC minutes, corporate credit spreads are
very narrow, and equity valuations are elevated relative to historical patterns, even after
taking into account the low level of interest rates.12 Business and consumer confidence is
high, which is also consistent with a higher shorter-run neutral rate of interest.
The Outlook
Having provided some context for how we might assess policy, I will turn to
some observations on the outlook. By any measure, overall growth in the second quarter
was strong. Real GDP increased at a 4-1/4 percent annual rate, a very rapid pace nine
years into the expansion. Looking ahead, it seems likely that growth will remain solid.
Confidence is high, private domestic demand momentum is solid, and recent fiscal
stimulus will continue to work its way through the economy, at least for the next year or
so.
The labor market is also strong. So far this year, payroll gains have averaged
more than 200,000 per month, a step-up from the 2017 pace and well above estimates of
the pace necessary to absorb new entrants into the labor force. Among prime-age
12
See Board of Governors (2018b).
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workers, the employment-to-population ratio is 79.3 percent, up almost 1 percentage
point over the past year. These developments are heartening, suggesting the tight labor
market is providing employment opportunities to more Americans. Nonetheless, this is
still about 1 percentage point below its previous cyclical peak, suggesting there may be
some room for further gains.
In another encouraging development, wage gains in the August report reached
their highest level since the depth of the financial crisis, although wage growth remains
moderate by historical standards. While a variety of wage measures have accelerated
over the past year and there is anecdotal evidence of worker shortages in some sectors
and regions, there is no evidence of rapid acceleration in the aggregate wage indicators.
At 3.9 percent, the August unemployment rate was about 1/2 percentage point
lower than the previous year. If unemployment continues to decline at the same rate as
we have seen over the past year, we will soon see unemployment rates not seen since the
1960s. Historically, the few periods when resource utilization has been at similarly tight
levels have tended to see elevated risks of either accelerating inflation or financial
imbalances.13 For instance, the inflation process may change in unexpected ways.
So far, the data on inflation remain encouraging, providing little signal of an
outbreak of inflation to the upside, on the one hand, and some reassurance that underlying
trend inflation may be moving closer to 2 percent, on the other. Core personal
consumption expenditures (PCE) prices have increased 2 percent over the past
12 months, consistent with the FOMC's objective. Survey measures of inflation
expectations remain stable in the lower end of the historical ranges, while market-based
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measures of inflation compensation remain stable at levels above the lows seen in 2016.
With various measures of underlying trend inflation having come in below our 2 percent
objective over a sustained period, it is important to sustainably achieve inflation around
2 percent to prevent an erosion of underlying trend inflation the next time the economy
faces a downturn and the federal funds rate hits its lower limit.14
The past few times unemployment fell to levels as low as those projected over the
next year, signs of overheating showed up in financial-sector imbalances rather than in
accelerating inflation. The Federal Reserve's assessment suggests that financial
vulnerabilities are building, which might be expected after a long period of economic
expansion and very low interest rates. Rising risks are notable in the corporate sector,
where low spreads and loosening credit terms are mirrored by rising indebtedness among
corporations that could be vulnerable to downgrades in the event of unexpected adverse
developments. Leveraged lending is again on the rise; spreads on leveraged loans and the
securitized products backed by those loans are low, and the Board's Senior Loan Officer
Opinion Survey on Bank Lending Practices suggests that underwriting standards for
leveraged loans may be declining to levels not seen since 2005.
While tightening resource utilization and loose financial conditions present upside
risks, recent foreign developments present downside risks. Trade policy has introduced
uncertainty. Growth in Europe and Japan has moderated from its strong pace of last year,
and political risks have reemerged in countries such as Italy. China is contending with
deleveraging and deceleration as well as a challenging trade environment. As U.S.
growth has pulled away from foreign growth, in part reflecting fiscal policy divergence,
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expectations of monetary policy divergence strengthened, contributing to upward
pressure on the dollar earlier this year. The resulting currency adjustments are
compounding challenges faced by some emerging market economies, along with a
complicated and unpredictable trade environment and gradually increasing interest rates.
Although capital flow reversals have been contained to several notably vulnerable
countries so far, I am attentive to the risk that a pullback from emerging markets could
broaden.
The Path of Policy
What are the implications for policy? Over the next year or two, barring
unexpected developments, continued gradual increases in the federal funds rate are likely
to be appropriate to sustain full employment and inflation near its objective. With
government stimulus in the pipeline providing tailwinds to demand over the next two
years, it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher
than the longer-run neutral rate. Further out, the policy path will depend on how the
economy evolves.
These developments raise the prospect that, at some point, the Committee's
setting of the federal funds rate will exceed current estimates of the longer-run federal
funds rate. Indeed, the median projection in the SEP has this property. This raises the
possibility of a flattening or inversion of the yield curve in the event that term premiums
do not rise from their currently very low levels.15
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Like many of you, I am attentive to the historical observation that inversions of
the yield curve between the 3-month and 10-year Treasury rates have had a relatively
reliable track record of preceding recessions in the United States.16 But unlike these
historical episodes, today the current 10-year yield is very low at around 3 percent, which
is well below the average of 6-1/4 percent during the decades before the crisis.
Part of the reason the 10-year Treasury yield is unusually low is that market
expectations of interest rates in the longer run are themselves quite low, as discussed
earlier. Another important reason the 10-year Treasury yield is very low is that the term
premium has fallen to levels that are very low by historical standards. According to one
estimate from Federal Reserve staff, the term premium has been slightly negative until
very recently and remains very low.17 By contrast, it was close to 100 basis points when
the spread between the 3-month and 10-year Treasury yields was at its peak of 325 basis
points in early 2010. This may temper somewhat the conclusions that we can draw from
historical yield curve relationships characterized by a substantially higher term premium.
If the term premium remains very low, any given amount of monetary policy tightening
will lead to an inversion sooner so that even a modest tightening that might not have led
to an inversion historically could do so today.
One reason the term premium may be lower than in the past is the changed
correlation between stock and bond returns, likely associated with changes in expected
inflation outcomes.18 The other driver of the low level of the term premium globally is
the asset purchases of central banks in several major economies.19 In this case, if the
term premium rises as the effect of asset purchase programs diminishes, the effect may be
to forestall an inversion of the long-dated yield curve.
It is worth highlighting that the flattening yield curve suggested by the SEP
median is associated with a policy path calibrated to sustain full employment and
inflation around target. So, while I will keep a close watch on the yield curve as an
important signal on financial conditions, I will want to interpret yield curve movements
as one of several considerations informing appropriate policy.
Indeed, the possibility that the projected policy path may have unintended
consequences is one of the compelling reasons for raising interest rates gradually. The
gradual pace of interest rate increases anticipated in the SEP median path should give us
some time to assess the effects of our policies as we proceed.
While the information available to us today suggests that a gradual path is
appropriate, we would not hesitate to act decisively if circumstances were to change. If,
for example, underlying inflation were to move abruptly and unexpectedly higher, it
might be appropriate to depart from the gradual path. Stable inflation expectations is one
of the key achievements of central banks in the past several decades, and we would
defend it vigorously.
Conclusion
Our challenge is to sustain full employment and inflation at 2 percent, which is
likely to warrant continued gradual increases in the federal funds rate. With fiscal
stimulus in the pipeline and financial conditions supportive of growth, the shorter-run
neutral interest rate is likely to move up somewhat further, and it may well surpass the
longer-run equilibrium rate for some period. Beyond the near term, how much the
neutral rate is likely to rise and whether it flattens or moderates further out will depend on
a variety of developments--such as whether fiscal stimulus is extended or expires,
whether foreign and trade risks grow or recede, and whether financial system
vulnerabilities extend. As such, the gradual pace of rate increases implicit in the SEP's
median policy path incorporates a degree of caution, which is appropriate, in my view.
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