Fed Simulations Call for Rate Hikes Soon The optimal path for short-term U.S. interest rates might be to start raising them soon and end the process quickly, according to research conducted by senior Federal Reserve economists. The Fed’s new “optimal control” study, completed in late November, is akin to putting the whole economy through a flight simulator to estimate how much fuel it needs to ride through a storm. Using a model known as FRB/US, Fed staffers simulate a path for the central bank’s benchmark interest rate–the federal funds rate–that results in the quickest possible return to low unemployment and stable inflation around 2%. The study finds the best time to start lifting the fed funds rate from near zero is right now, in the fourth quarter of 2014, followed by increases to 1.4% by the fourth quarter of 2015, 2.6% by the fourth quarter of 2016 and 3.5% by the end of 2017. Looking out past 2020, the simulations never result in short-term rates above 4%. These simulations are noteworthy in part because Fed Chairwoman Janet Yellen pays attention to them. She highlighted earlier versions of optimal control exercises in speeches in 2012, citing the work as evidence the Fed should take its time raising rates. Those earlier simulations had notably different outcomes than the news ones. They pointed to the optimal time for liftoff as late 2015, followed by a steep path of rate increases that pushed the benchmark to near 5% by 2020. Several factors have changed since the 2012 simulations. The jobless rate has come down faster than Fed officials expected when the simulations were done two years ago. In mid-2012, the jobless rate exceeded 8% and Fed officials expected it to retreat slowly to between 7% and 7.7% by the end of 2014. Instead it was 5.8% in October. That helps explain the earlier liftoff produced by the model now. (The fact that Fed officials and their models were so wrong about the trajectory of unemployment is one reason to treat all of these model simulations with great caution–more on that below.) Though the authors don’t specifically cite it, the economic profession’s debate about “secular stagnation” lurks in the changing simulations. The secular stagnation idea, popularized by Harvard University professor Lawrence Summers, holds that the economy doesn’t grow as fast as it used to because of low worker productivity and labor force growth. That in turn means interest rates don’t need to go as high as previously thought once they do start rising. Fed officials have reduced their estimate of how high short-term interest rates need to go in the long-run, from 4.25% in 2012 to 3.75% more recently, which explains the lower amplitude of rates in the new simulations. Other factors are at play. As noted by the authors–Flint Brayton, Thomas Laubach, and David Reifschneider–the Fed’s views about the causes of inflation and its interplay with the economy and interest rates also have evolved since the 2012 simulations. The Fed’s updated models see inflation as more inertial and less responsive either to slack or to changes in the fed funds rate than previously thought. The simulations suggest that new inflation view should encourage officials to take a slower path of rate increases than thought before. At the same time, it should make them reluctant to allow inflation to overshoot the 2% goal, because it could be hard to get back down. Ms. Yellen, in her 2012 speeches, warned it would be “imprudent” to put too much weight on these simulation exercises, a view seconded by the Fed researchers, who say the models should be treated with a “high degree of caution” as a guide to actual interest rate policy. As the latest shifts show, the models themselves are imperfect and subject to change. For example, the recent global downdraft in inflation, driven in part by commodity price declines, could change the results again if it persists or deepens. Fed officials are expecting inflation to gradually rise to 2%. Moreover, the models are sensitive to how much weight officials put on making interest rate changes steady and predictable. The more comfortable they are making swift changes to rates, the longer they can wait before raising them. Still, the new exercise does provide a window into how thinking at the Fed is evolving as it nears interest rate liftoff, after holding the fed funds rate near zero since December 2008. In comments this week, Fed Vice Chairman Stanley Fischer and New York Fed President William Dudley both strongly suggested the central bank is inclined to start raising rates in the months ahead even though inflation is lower than the central bank’s 2% target. The new simulations support that view. At the same time, the two officials focused a great deal of attention on what happens once the Fed does start raising rates. What is the path of rate hikes going to look like? The new simulations suggest it will be modest indeed.
Posted on: Fri, 05 Dec 2014 14:54:41 +0000
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