Gradual Federal Reserve rate hikes remain appropriate, and while this may invert the yield curve, Fed Gov. Lael Brainard said she believes there are reasons to “temper somewhat” implications of a negative curve.
“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,” Brainard told the Detroit Economic Club on Wednesday, according to prepared text released by the Fed. “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.”
While she’s “attentive” to the implications of an inverted yield curve and the connection to recessions, Brainard said, that unlike in the past, the 10-year Treasury yield “is very low,” in part because of market expectations of interest rates, as well as term premium is low by historical standards.
“This may temper somewhat the conclusions that we can draw from historical yield curve relationships characterized by a substantially higher term premium,” Brainard said. “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. The other driver of the low level of the term premium globally is the asset purchases of central banks in several major economies. 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.”
The Summary of Economic Projections expects the yield curve to flatten as rates are raised to keep employment and inflation levels near current reads. “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.”
And while gradual rates seem appropriate now, she said, “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.”
Brainard said she thinks of the “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.” The short-term neutral rate fluctuates, based on changes in economic conditions.
“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,” Brainard said. “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.”
The longer-run trend is estimate in the range of 2.5 to 3.5% in nominal terms. “This range lines up well with the most recent median estimate of the longer-run federal funds rate in the FOMC SEP, which is just below 3%,” she noted. “By these estimates, the longer-run neutral rate has fallen considerably from the estimated range in earlier decades of 4 to 5%.”
The unemployment rate falling and the federal funds rate rising, Brainard said, “suggests that the short-run neutral interest rate likely has also increased” and could rise “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.”
