William C Dudley: Remarks at the 2015 US Monetary Policy Forum
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the 2015 US Monetary Policy Forum, New York City, 27
February 2015.
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Jonathan McCarthy, Paolo Pesenti and Joseph Tracy assisted in preparing these remarks.
It is a great pleasure to have the opportunity to comment on this year's Monetary Policy
Forum paper, "The Equilibrium Real Federal Funds Rate, Past, Present and Future." Let me
preface my remarks with the reminder that what I have to say today reflects my own views
and not necessarily those of the Federal Open Market Committee (FOMC) or the Federal
Reserve System.
I think this is a timely topic because it is relevant to several questions that are particularly
important in the current environment. First, if one were to use a Taylor-type rule as a guide to
assess the stance of monetary policy, what equilibrium real federal funds rate would one
currently use in the formula? Given the performance of the economy in recent years, I think it
would be very hard to justify the typical assumption of a 2 percent rate.
Second, what will this equilibrium real rate be in the future? This is particularly germane right
now given that short-term forward interest rates derived from the Treasury yield curve have
come down sharply since late 2013. For example, the 1-year forward rate, 9 years ahead has
declined sharply over the past year, falling from around 5 percent in December 2013 to just
under 3 percent currently. What can explain such a large shift in forward rates at such a long
time horizon?
Third, when U.S. monetary policy is normalized, how fast should we raise short-term interest
rates? In other words, what is the appropriate path back to the long-run equilibrium real
federal funds rate, shallow or steep?
In my view, the paper reaches five major conclusions - conclusions that I find myself broadly
in agreement with:
• There are many factors that influence the level of the equilibrium real short-term
interest rate. Real potential GDP growth may be one factor, but the real equilibrium
rate is also affected by financial conditions, uncertainty and risk aversion, financial
market performance (e.g., bubbles and busts) and the degree of restraint exerted by
the stringency of banking and financial market regulation.
• There is little evidence supporting the so-called "secular stagnation" view that the
equilibrium real short-term rate will persistently remain near or below zero.
• The equilibrium real short-term rate is non-stationary. Thus, it will not necessarily
revert back to some long-run average value.
• U.S. and global markets are integrated to a significant degree. As a result, the
equilibrium real short-term rates both here and abroad will tend to move together.
This seems especially germane in the current environment in which very low
longterm government bond yields in Europe and Japan appear to have been an
important factor in pulling U.S. long-term yields lower over the past year or so.
• Given the uncertainties about the current and future levels of the equilibrium real
short-term rate, an inertial policy rule may lead to better outcomes. As a
consequence, the process of normalization of monetary policy should proceed
cautiously, with short-term interest rates more likely to rise only gradually toward the
equilibrium real short-term rate.
That said, I think the paper leaves some open questions worthy of further exploration. First,
although the equilibrium real short-term interest rate, which I will refer to as r*, is only loosely
related to real potential GDP growth, could we do better if we were to decompose real
potential GDP into its components - such as the growth rates of labor input and productivity
- and examine the relationship between r* and each component separately? Second,
accepting the principle that an inertial monetary policy rule performs better as uncertainty
about the level of the equilibrium real short-term rate increases, what does this imply for
monetary policy under current circumstances? Third, in light of the evidence on the volatility
of the equilibrium real short-term rate, what are the implications of adopting a Taylor-type
rule as a benchmark for monetary policy evaluation? I will argue that in the U.S. context, a
Taylor-type rule - even an inertial one - is an incomplete guide for policy because it does not
explicitly include financial variables that are important factors in the transmission of monetary
policy to the real economy. Finally, I will briefly comment on the issue of secular stagnation
and my views on the long-term equilibrium real federal funds rate.
Turning to the first issue of the relationship between real potential GDP growth and the
equilibrium real short-term interest rate, the authors find, at best, only a very loose
relationship. I would have welcomed some further work here, more closely focused on the
components of real potential GDP growth - such as labor input and productivity - and their
potential links to the level and dynamics of the equilibrium real short-term rate. First, I would
look more closely at the demographic factors that influence the amount of labor input. In my
view, it seems plausible that when the labor force is rising rapidly, this might put upward
pressure on r* by increasing the demand for capital needed to equip the new army of
workers. This might have been particularly relevant during the late 1970s when the labor
supply in the U.S. was rising rapidly due to the influx of the baby boom generation into the
workforce and the climb in female participation rates. Second, the equilibrium real short-term
rate might be influenced by the productivity growth rate. If productivity growth were high, one
might expect that the return on capital might also be elevated, putting upward pressure on
real rates. The late 1990s surge in productivity growth during the internet technology boom
seems to be a good example of this type of phenomenon.
If the growth in labor input and productivity were positively related with the equilibrium real
short-term rate, then in the current environment this would be consistent with a relatively low
r*. The potential labor force has grown very slowly in recent years (less than a 1⁄2 percent
annual rate over the past five years), and productivity growth has been subdued - running at
only 1 to 11⁄2 percent annual rate on average over the past few years. In sum, by focusing on
the components rather than on the overall real potential GDP growth rate, one might find
stronger and more persistent relationships with the equilibrium real short-term interest rate.
The second issue that I want to briefly explore concerns the degree of uncertainty about the
equilibrium real short-term rate and its implications for monetary policy. The paper argues
quite convincingly, I think, that when this uncertainty is high, then an inertial policy rule may
be preferable - that is, would lead to higher expected welfare.
While I think this is true, I also think it is important not to overstate the implications of this
conclusion in today's environment. Currently, short-term rates in the U.S. are low relative to
the standard formulation of the 1999 Taylor Rule. This implies either that U.S. monetary
policymakers think that the equilibrium real short-term rate is currently depressed, or that
they judge that a monetary policy stance more inertial than the Taylor 1999 standard is more
appropriate for the FOMC to achieve its mandated employment and inflation objectives. My
own view is that it is a bit of both. Lingering headwinds related to the financial crisis suggest
that r* is temporarily depressed. In addition, there are some reasons to be cautious in how
early and fast one should raise short-term interest rates. In particular, inflation is projected to
stay for some time below the Fed's objective of 2 percent for the PCE deflator and
marketbased measures of inflation compensation are depressed currently. Also, as I have noted
elsewhere, I believe that the risks of lifting the federal funds rate off of the zero lower bound a
bit early are higher than the risks of lifting off a bit late. This argues for a more inertial
approach to policy.
That said, it is important not to overemphasize uncertainty to justify a policy of persistently
low short-term interest rates. There are also risks from too much policy inertia. An inertial
approach works well as long as inflation expectations stay well-anchored. But, if a delay in
monetary policy normalization or a very shallow trajectory in normalizing short-term interest
rates were to cause inflation expectations to move meaningfully above our 2 percent inflation
objective, then an inertial policy would likely become detrimental in achieving the FOMC's
objectives.
The third, and related, issue I want to address is the care needed in using rules, such as
Taylor 1999, as a guide to policy. As the paper convincingly shows, over time, financial
market conditions have become a much more important factor in evaluating the appropriate
setting of monetary policy and the level of short-term interest rates. This reflects several
factors. First, over the past few decades the U.S. capital markets have grown in size and
scope, and our financial system has become much less bank-centric. This has loosened the
linkage between the federal funds rate and financial market conditions. Second, the U.S.
economy and financial markets have become more interconnected globally. Thus, the impact
of U.S. monetary policy has become more diffused, and financial market conditions have
come to depend increasingly not only on developments at home, but also on developments
abroad. As an example, the current low level of U.S. Treasury bond yields reflects, at least in
part, the fact that long-term interest rates in Europe and Japan are much lower.
While simple policy rules provide useful benchmarks for policymakers, their very virtue - their
simplicity - is also a significant shortcoming. Policy rules, especially those with fixed values
for r*, cannot capture all of the information that is relevant for policymaking. In particular,
such rules do not capture the fact that the linkage between the federal funds rate and both
financial markets and global conditions can be very loose and shift over time. This is a critical
shortcoming because this looseness affects the stability of the relationship between
monetary policy and economic outcomes.
If the relationship between monetary policy, financial conditions and the real economy were
tight and stable over time, then following a relatively simple and unchanging policy rule would
likely generate acceptable results. However, if the transmission of monetary policy to the real
economy is more variable and uncertain, as I believe it is, then monetary policy cannot be
put on autopilot guided only by a fixed policy rule.
As an example, one significant conundrum in financial markets currently is the recent decline
of forward short-term rates at long time horizons to extremely low levels - for example, the
1-year nominal rate, 9 years forward is about 3 percent currently. My staff's analysis
attributes this decline almost entirely to lower term premia. In this case, the fact that market
participants have set forward rates so low has presumably led to a more accommodative set
of financial market conditions, such as the level of bond yields and the equity market's
valuation, that are more supportive to economic growth. If such compression in expected
forward short-term rates were to persist even after the FOMC begins to raise short-term
interest rates, then, all else equal, it would be appropriate to choose a more aggressive path
of monetary policy normalization as compared to a scenario in which forward short-term
rates rose significantly, pushing bond yields significantly higher.
In closing, I agree with the authors that it is very much premature to accept the hypothesis
that we have entered a sustained period of secular stagnation. That said, however, I do think
that the real potential GDP growth rate will be lower over the medium term, held down by
much slower growth of labor input and an anticipated continuation of lackluster productivity
growth performance. If I am correct, this does have implications for the longer-run value of r*.
My point estimate is that the longer-run value of the federal funds rate is 31⁄2 percent, well
below its long-run historical level of 41⁄4 percent. At the same time, I also have little
confidence about the accuracy of this specific estimate. So you see that I come out in a very
similar place as the authors of this year's Monetary Policy Forum paper. They suggest that
the long-run equilibrium real federal funds rate might be in the range of 1 to 2 percent. Add
on 2 percent inflation, you end up in just about the same place as my current long-term 31⁄2
percent nominal federal funds rate point estimate.
Thank you for your kind attention.
2015 U.S. Monetary Policy Forum
The Equilibrium Real Funds Rate: Past, Present and Future