Fed Leaves Rates Unchanged, Current Range Deemed “Accommodative”

On Wednesday, November 1, the Federal Open Markets Committee (“FOMC”) decided to leave its interest rate, the federal funds rate, unchanged at a range of 1.00 to 1.25 percent. Although the effects of the past hurricanes have reversed the longer trend in both employment and inflation, the hurricanes’ impacts are expected to fade and the longer-trend will reappear. In the face of current fundamental macroeconomic conditions, the FOMC judges that the current stance of monetary remains “accommodative”.

Consistent with its statutory mandate, the FOMC seeks to foster maximum employment and price stability. Nationwide, the Bureau of Labor Statistics reported that payroll employment fell by 33,000 in September. However, analysis of the state-level data identified the job declines in Florida as the primary driver of decrease reported nationwide. This suggests that the nationwide fall in the number of jobs was likely related to the hurricanes, an impact expected to temporary, and that the number of jobs around the country would have continued to rise if the number of payroll jobs in the state of Florida had remained flat over the month of September. Despite the decline in payroll employment across the country, the unemployment rate remained low, falling to 4.2 percent and the labor force expanded, suggesting that the underlying labor market fundamentals remain in place.

Although the employment situation continues to improve, despite ephemeral shocks, price stability poses a concern. It is generally accepted that price stability means a 2 percent annual increase in the consumer price level. Although recent readings of CPI inflation have exceeded 2 percent, deeper analysis indicates that the current rate of inflation reflects the response of energy prices to the recent hurricanes, suggesting that the current rate is temporary and inflation will return to a sub-2 percent rate in the near future. Despite the sub-2 percent rate of inflation, the median FOMC member expects inflation to return 2 percent in the near future.

The FOMC statement also noted that the current range of the federal funds rate is accommodative. Although monetary policy making is not “rules-based”, analysts can rely on the Taylor rule to assess an appropriate level of the federal funds rate. As a result, a Taylor rule is one method for assessing both the existence and the extent of accommodation.

Previous analysis discussing the components of the Taylor rule demonstrated that the macroeconomic conditions imply that the federal funds rate can be presently determined by the rate of inflation and r*, the natural rate of interest that reflects the strength of broad economic fundamentals such as investment growth, savings rates and trends in productivity growth. This is because the output gap is virtually zero and CPI inflation reached 2 percent in the third quarter of 2017, though growth of consumer prices is expected to slow somewhat in the coming months.

ἰ = ∏ + r*

While prices of consumer goods are observable as various metrics of the prices faced by consumers are measured by the Bureau of Labor Statistics, the Bureau of Economic Analysis, and other organizations, r* is unobservable. However, analysts at the Federal Reserve Bank of San Francisco have estimated that r* has been trending down since the 1960s and is currently close to zero. As of the second quarter of 2017, r* was estimated to be -0.22 percentage points. Using CPI inflation of 2.0 percent, its annual rate of growth over the third quarter of 2017 and an r* of -0.22, the latest estimate as of the second quarter of 2017, means that the federal funds rate should be 1.78 percent. Since the federal funds rate is actually below this level, then monetary policy can be interpreted as accommodative.

Since r* is a key determinant of the federal funds rate, then forming expectations about the future of r* will inform forecasts of the federal funds rate. If price stability remains at an annual rate of 2 percent inflation (or returns to 2 percent as FOMC members presume will take place using PCE inflation) and economic growth remains near its potential, then, after the removal of accommodation, additional increases in the federal funds rate and other market rates by extension, will depend on a rise in r*.

Currently, the rate on the U.S. 10-Year Inflation-indexed Treasury Note, which adjusts the nominal rate on the U.S. 10-Year Treasury note for CPI inflation, implies that r* should rise to 0.50 percentage points. The implied r* taken from the September 20, 2017: FOMC Projections materials, indicates that the median estimate of the long-run r* is 0.80 percent, the difference between the median long-run federal funds rate and the median PCE inflation. Assuming then that economic growth remains near its potential and that inflation remains at 2 percent, or returns quickly after the hurricanes’ effects fade, would suggest that the long-run neutral federal funds rate should reach between 2.5 and 2.8 percent, approximately 5 or 6 additional 25 basis points rate hikes.



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