Lael Brainard: Normalizing monetary policy when the neutral interest
rate is low
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the Stanford Institute for Economic Policy Research, Stanford, California, 1
December 2015.
* * *
Let me begin by noting that my comments today will not address the timing of liftoff for the
federal funds rate.1
Recent months have seen increased anticipation of the normalization of monetary policy in the
United States. Many observers interpret normalization to mean a tightening cycle similar in
pace to previous cycles, such as those from 1994 to 1995 and from 2004 to 2007, with the
effect of returning interest rates to the level viewed as normal in the decades before the crisis.
The Federal Reserve describes normalization as "steps to raise the federal funds rate and
other short-term interest rates to more normal levels."2 But what do we mean by "more normal
levels"? A broad deterioration in foreign growth prospects, together with greater risk sensitivity
in the wake of the crisis and changes in the rate of potential output growth, may be contributing
to a "new normal." The new normal is likely to be characterized by a lower level of interest
rates than in the decades preceding the crisis, which counsels a cautious and gradual
approach to adjusting monetary policy.
The Benchmark Neutral Rate
The appropriate pace and target for normalizing monetary policy depend centrally on
understanding the neutral rate of interest. The nominal neutral interest rate is the level of the
federal funds rate that is consistent with output growing close to its potential rate with full
employment and stable inflation.3 The appropriate benchmark for assessing the stance of
monetary policy is the gap between the policy rate and the nominal neutral rate of interest:
When the federal funds rate is below the nominal neutral rate, monetary policy is
accommodative, and, when it is above the neutral rate, policy is contractionary. For this reason,
many monetary policy rules, such as the well-known Taylor rule, incorporate an estimate of
the neutral real interest rate as a critical parameter along with the target rate of inflation.4
Although the neutral rate is a critical benchmark for monetary policy, it changes over time in
response to important changes in economic conditions, necessitating corresponding
adjustments in monetary policy in order to restore the economy to full employment. For
instance, when there are modest adverse shocks to demand that lead to modest reductions in
the shorter-run neutral rate, monetary policy can provide enough support to keep the economy
at full employment simply by reducing the policy rate commensurate with the decline in the
nominal neutral rate. However, when the adverse shocks to demand are sufficiently severe to
push the nominal neutral interest rate substantially below zero, as they were during the Great
Recession, monetary policy confronts the zero-lower-bound constraint, at which point the
federal funds rate cannot fall low enough to provide the necessary degree of accommodation
without becoming negative. This was the case in the United States for several years following
the crisis and remains true today in a number of advanced foreign economies. That is why
monetary policymakers in the United States and several other major economies have been
compelled to use additional unconventional tools to promote full employment and target
inflation, such as forward guidance and asset purchases.
The neutral rate of interest is not directly observable, but we can back out an estimate of the
neutral rate by relying on the observation that output should grow faster relative to potential
growth the lower the federal funds rate is relative to the nominal neutral rate. In today's
circumstances, the fact that the U.S. economy is growing at a pace only modestly above
potential while core inflation remains restrained suggests that the nominal neutral rate may not
be far above the nominal federal funds rate, even now. In fact, various econometric estimates
of the level of the neutral rate, or similar concepts, are consistent with the low levels suggested
by this simple heuristic approach.5
The Past and Future Neutral Rate
In assessing the policy path ahead, the critical question is whether a low neutral rate is likely
to be a "new normal" in the longer run or whether the neutral rate is soon likely to increase
back to levels considered normal in the decades before the crisis. To answer this question, it
is helpful to use economic forecasts, market-implied expectations, and econometric models to
assess where real interest rates are expected to be in the longer run, and compare them with
the levels that prevailed in the decades before the crisis. In doing so, it is important to abstract
from shocks that are transitory or cyclical and thus likely to fade away over a year or two.6
Starting with economic forecasts, Blue Chip Forecasts publishes projections of the federal
funds rate and consumer price index (CPI) inflation 6 to 10 years into the future, when the
economy is typically expected to be near full employment. The implied Blue Chip consensus
longer-run real federal funds rate averaged around 2.2 percent in the two decades preceding
the crisis, which is close to the level of the intercept term in the Taylor (1993) rule, which in
turn is based on empirical analysis of the period from the mid-1980s to the early 1990s. In
contrast, the Blue Chip consensus longer-run rate is currently around 1.1 percent, about 1
percentage point lower than the pre-crisis average.7
Similarly, although the Federal Open Market Committee (FOMC) has not explicitly defined
"normal," the central tendency or the median of the longer-run level of the federal funds rate in
the Summary of Economic Projections (SEP) might reasonably be considered a rough proxy.
By this proxy, forecasts of the neutral rate have moved down noticeably over the past several
years. The median projection of the longer-run level of the real federal funds rate was 2-1/4
percent in January 2012, when projections of the longer-run federal funds rate were first
included in the SEP. By comparison, the median projection for the longer-run real federal funds
rate had fallen by 3/4 percentage point to 1-1/2 percent in the most recent SEP.8
Market measures of expected forward rates evidence a similar decline. For example, we can
back out an implied 1-year real rate 10 years from now from the Treasury inflation-protected
securities, or TIPS, yield curve. The most recent readings are around 1.3 percent, close to 2
percentage points below the average rate from 1999 through 2007. Swaps prices tell a similar
story. The implied expected 1-year real rate 10 years from now is currently close to 1 percent,
again well below levels prior to the financial crisis.
Finally, some of the econometric models used to estimate the current neutral rate, or closely
related concepts, can also be used to assess whether low neutral rates are likely to persist.
While estimates will depend on the model specification, several models estimate that the
neutral rate will remain low for some time to come. Laubach and Williams, for example,
estimate that the natural rate, a concept closely related to the neutral rate, likely will remain
near zero for the foreseeable future.9
Why Is the Neutral Rate Low?
With a variety of estimates suggesting that the neutral rate of interest is likely to remain low
relative to historical norms for some time, it is important to assess the underlying causes and
their likely persistence. There are a host of factors that could lead the neutral rate to remain
depressed in the longer run--ranging from the low level of world real interest rates, which
affects the United States via the exchange rate and financial market channels, to slow-moving
secular trends in the labor force and productivity, to persistent changes in risk perceptions
stemming from the crisis.
Although tight domestic credit conditions and concerns about downside risks to asset prices
and domestic demand were the dominant drivers early in the recovery, the foreign outlook has
become increasingly important as a source of downward pressure on the neutral rate in the
past few years. In addition to concerns about weak demand in Japan and the euro area, more
recently foreign growth concerns have broadened to include China, which is navigating difficult
structural as well as cyclical adjustments. The financial reverberations from China are
adversely affecting commodity exporters and emerging markets more broadly, and weak
growth trajectories are now the norm in much of the world, pushing down interest rates globally.
The broad-based reduction in interest rates in the rest of the world, by increasing demand for
U.S. assets, puts upward pressure on the dollar, which in turn implies downward pressure on
the U.S. neutral rate. One way to think about the spillover from abroad is how much adjustment
in the federal funds rate might be necessary to insulate domestic employment from an
appreciation in the dollar that is expected to persist. Let's take the roughly 15 percent real
appreciation of the dollar that we have seen since June 2014. According to the Board's FRB/US
model, it would require lowering the path of the federal funds rate by roughly 1 percentage
point over the medium term to insulate domestic employment from the 15 percent stronger
exchange rate in inflation adjusted terms. In the neighborhood of the zero lower bound, this
shift down implies a delay in the date of liftoff and a shallower path for the federal funds rate
over several years. In effect, this spillover from abroad implies some limitations on the extent
to which U.S. monetary conditions can diverge from global conditions.
Going forward, many observers expect global growth to stabilize and eventually move higher,
easing pressure on the dollar and on commodity prices and leading to a higher neutral interest
rate globally.10 However, as foreign economies face structural as well as cyclical adjustments,
the speed at which the stabilization and recovery of foreign growth takes place is highly
uncertain, and there is a risk that this influence on the neutral rate could fade very slowly.
Moreover, there are downside risks to the foreign outlook.
Other factors likely pushing down the current neutral rate may prove even more persistent.
Importantly, expectations that the economy's growth potential has fallen could contribute to a
persistent decline in the neutral rate. Indeed, there is evidence that growth in the labor force,
and perhaps productivity, have slowed persistently in recent years. After increasing noticeably
over much of the post-World War II period, the labor force participation rate flattened out over
the 1990s and began to decline in the early 2000s as the baby boom generation approached
retirement. Most recently, the pace of decline has quickened, with the participation rate
declining 1/2 percent per year, on average, over the recovery.11 Productivity growth has also
slowed, averaging just 1 percent per year over the recovery, about half the pace over the 50
years prior to the financial crisis.12 Given this data, the Congressional Budget Office now
estimates that the growth rate of potential output is only 1.7 percent currently, less than half
the rate during the 50 years before 2008. Nevertheless, although there is evidence of a
connection between low potential output growth and a low neutral rate, as pointed out by
Hamilton and others, the relationship is not precisely estimated, which leaves considerable
uncertainty about the magnitude of the effect.13
Finally, investors' risk sensitivity appears to have been altered by the experience of tail risks
during the crisis, which could have a persistent depressing effect on the neutral rate. To the
extent that investors or firms are more attuned to the risks associated with capital investments
than before the financial crisis, it increases the premium for risky investments, or the difference
in return between a risk-free investment, such as overnight reserves, and somewhat riskier
investment opportunities. A higher risk premium necessitates a lower risk-free rate to
encourage the same amount of riskier investments as previously. Consistent with this
explanation, there is evidence that the gap between the return to capital investment and the
risk free rate has risen. For example, according to dynamic stochastic general equilibrium
models estimated by the Federal Reserve Board and the Federal Reserve Bank of New York,
the natural rate of interest has been held down during the recovery by shocks that increase
the difference between the marginal product of capital and the risk free rate, pushing down
investment and reducing the level of capital.14 In addition, a simple measure of the marginal
product of capital suggests that the return to capital investment has not changed very much,
or perhaps has even increased, over the past decade despite the decline in risk free rates.15
Implications for the Path of Monetary Policy
Before addressing what a persistently low neutral interest rate might mean for the
normalization of monetary policy, it is helpful to review inflation developments. Because the
federal funds rate is the real rate plus the expected rate of inflation and because it is the real
rate that influences economic activity, the amount of monetary accommodation represented
by a given nominal level of the federal funds rate decreases as expected inflation declines. In
11
Population growth has also moved gradually lower in the United States, though the effect has not been as large
as in some foreign economies, where the size of the population is now stagnant or falling.
12
It is unclear how persistent recent low rates of measured productivity growth will be. While weak investment
levels, particularly early on in the recovery, likely contributed to lower productivity gains, investment levels going
forward could be closer to historical norms. Also, recent technological gains may eventually contribute strongly
to productivity growth; see, for example, Baily, Manyika, and Gupta (2013). In addition, there is evidence that
some of the contribution of technology gains to productivity growth is being understated; see, for example, Byrne
and Pinto (2015), Byrne and Corrado (2015), and Byrne, Oliner and Sichel (2015).
13
See Hamilton and others (2015).
14
See Del Negro and others (2015). In these models, the natural rate of interest is defined as the "rate of interest
that would obtain if all prices and wages had adjusted so as to bring the level of economic activity to its
fullemployment rate."
15
See Gomme, Ravikumar, and Rupert (2015).
a low neutral rate environment, it is especially important to guard against extended periods of
below-target inflation, which may lead inflation expectations to drift lower.
It is thus notable that inflation has been below our 2 percent target for 3 years. Current
belowtarget levels of inflation in part reflect disinflationary pressures from abroad, including lower
import prices and lower commodity prices, which are likely to fade over time. However, inflation
has been stubbornly low, even excluding energy prices. Over the 12 months ending in October,
core personal consumption expenditures, or PCE, prices, which exclude the often volatile
categories of food and energy, increased 1.3 percent, and the 12-month change in core prices
has been around 1-1/4 to 1-1/2 percent since the beginning of 2013. The persistent weakness
in core price inflation deserves continued vigilance.
In determining the outlook for inflation, the gravitational force of long-term inflation expectations
is especially important. Some survey measures of inflation expectations have declined
recently. For example, the University of Michigan Surveys of Consumers median measure of
inflation expectations at a 5-to-10 year horizon was 2.6 percent in November and has averaged
2.7 percent over the past year, slightly below the average reading over the past decade of 2.9
percent. Projections from the Survey of Professional Forecasters also suggest that
10-yearahead inflation expectations edged lower this quarter, although they have remained at or very
near 2 percent since the end of 2012.
Market-based measures of inflation compensation at longer-term horizons, such as inflation
swaps and the difference between nominal and inflation-indexed Treasury bond yields, have
declined more noticeably over the past year and a half. Although it is difficult to precisely
disentangle the contribution of changes in inflation expectations, liquidity premiums, and
inflation risk premiums to this downward shift, some decompositions suggest that, while
expected inflation may not have declined much, market participants may be placing a
somewhat greater likelihood than previously on episodes of below-potential growth being
accompanied by below-target inflation. Thus, the decline in measures of inflation expectations
warrants close monitoring.
The slow progress on inflation, together with the likely low level of the longer-term neutral real
rate and the slow pace at which the very low shorter-term rate may move to the longer-term
rate, suggest that the federal funds rate is likely to adjust more gradually and to a lower level
than in previous expansions. In short, "gradual and low" is likely to be the new normal.
In addition, the combination of a low neutral real rate with slow progress on inflation suggests
a greater likelihood of hitting the zero lower bound than in previous decades, when the neutral
rate was probably much higher. The lower the longer-term nominal neutral rate is, the smaller
in magnitude an adverse economic shock must be to push growth sufficiently below potential
to necessitate a nominal federal funds rate below zero to provide accommodation. Assuming
there has not been a material reduction in the frequency and severity of negative shocks since
the pre-crisis period, the implication is that the probability of being constrained by the zero
lower bound is greater than prior to the crisis.
Although empirical analysis suggests that unconventional tools affect the economy through the
same channels as the federal funds rate, even so, there are greater costs and uncertainties
associated with unconventional policies relative to changes in the federal funds rate. 16As a
result, policy is likely to remain more constrained at the zero lower bound than above it. As the
probability of hitting the zero lower bound increases, the asymmetry in policy flexibility
becomes more pronounced. Because we have more space to respond by raising rates if
inflationary forces accelerate than by cutting rates if disinflationary forces emerge, when
nominal neutral rates are likely to be lower on average, we should be cautious about raising
rates, do so gradually, and carefully assess the effects on economic and financial conditions
as we go. Moreover, because the Federal Reserve's asset holdings help maintain
accommodative financial conditions, it would be prudent to maintain reinvestments until the
normalization of the federal funds rate is sufficiently far along to allow room to cut nominal
rates if economic conditions deteriorate.
The asymmetry of policy flexibility at the zero lower bound also arises when there is uncertainty
about the level of the neutral real rate. As discussed in recent papers, if there is significant
uncertainty about the level of the neutral real rate, risk management considerations suggest
that policymakers should respond cautiously to signs that the neutral real rate may be rising,
particularly when the policy rate is close to the zero lower bound.17 In the presence of
uncertainty, there is a risk that the actual neutral real rate is either higher or lower than current
estimates of the neutral real rate, and the stance of policy will therefore be either more
accommodative or more restrictive than intended. If the actual neutral rate is higher than
estimated, and policy is more accommodative than intended, the stance of policy can be readily
tightened later to restrain any buildup in inflationary pressures. But, if the actual neutral real
rate is lower than estimated, and the stance of monetary policy is tighter than intended,
unexpected policy restraint may prove difficult to offset later with more accommodative policy
because the policy rate is already close to the zero lower bound.
Finally, there is a risk that with persistently lower neutral rates, there may be greater pressures
for investors to reach for yield, increasing the demand for risky assets. As a result,
macroprudential policy may take on greater importance to guard against financial stability risks.
Since the crisis, the Federal Reserve and other regulatory agencies have implemented a
number of new rules to strengthen capital, liquidity, and risk management at the largest
financial institutions. Many of these rules are "through the cycle" safeguards, meaning that
they impose structurally higher standards. In addition, when the risks to financial stability
increase, the Federal Reserve, in consultation with the other banking agencies, can
temporarily increase the amount of capital that large banks are required to hold in order to
build resilience at these institutions and to restrain undue risk-taking on a cyclical basis.
Conclusion
A variety of evidence suggests that the longer-run neutral rate is lower now than it has been
historically, and that the very low shorter-run neutral rate may adjust to it very slowly, due to a
combination of weaker foreign demand growth, greater risk sensitivity as a result of the crisis,
higher risk premiums for productive investment, and lower growth in potential output. The lower
neutral rate means the normalization of the federal funds rate is likely to follow a more gradual
and shallower path than in previous cycles, although the actual path will be determined by
economic conditions. It also implies that the likelihood of the federal funds rate hitting the zero
lower bound will be persistently greater than it has been previously, which could make it more
difficult to achieve our objectives of full employment and 2 percent inflation. With the nominal
neutral interest rate lower than in the past, and with policy options being more limited if
conditions deteriorate than if inflationary pressures accelerate, the asymmetry in
riskmanagement considerations counsels a cautious and gradual approach.
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