Friday, October 20, 2017

Yellen: "A Challenging Decade and a Question for the Future"

by Bill McBride on 10/20/2017 08:00:00 PM

From Fed Chair Janet Yellen: A Challenging Decade and a Question for the Future. Excerpt:

A Key Question for the Future

As the financial crisis and Great Recession fade into the past and the stance of monetary policy gradually returns to normal, a natural question concerns the possible future role of the unconventional policy tools we deployed after the onset of the crisis. My colleagues on the FOMC and I believe that, whenever possible, influencing short-term interest rates by targeting the federal funds rate should be our primary tool. As I have already noted, we have a long track record using this tool to pursue our statutory goals. In contrast, we have much more limited experience with using our securities holdings for that purpose.

Where does this assessment leave our unconventional policy tools? I believe their deployment should be considered again if our conventional tool reaches its limit--that is, when the federal funds rate has reached its effective lower bound and the U.S. economy still needs further monetary policy accommodation.

Does this mean that it will take another Great Recession for our unconventional tools to be used again? Not necessarily. Recent studies suggest that the neutral level of the federal funds rate appears to be much lower than it was in previous decades.  Indeed, most FOMC participants now assess the longer-run value of the neutral federal funds rate as only 2-3/4 percent or so, compared with around 4-1/4 percent just a few years ago.  With a low neutral federal funds rate, there will typically be less scope for the FOMC to reduce short-term interest rates in response to an economic downturn, raising the possibility that we may need to resort again to enhanced forward rate guidance and asset purchases to provide needed accommodation.

Of course, substantial uncertainty surrounds any estimates of the neutral level of short-term interest rates. In this regard, there is an important asymmetry to consider. If the neutral rate turns out to be significantly higher than we currently estimate, it is less likely that we will have to deploy our unconventional tools again. In contrast, if the neutral rate is as low as we estimate or even lower, we will be glad to have our unconventional tools in our toolkit.

The bottom line is that we must recognize that our unconventional tools might have to be used again. If we are indeed living in a low-neutral-rate world, a significantly less severe economic downturn than the Great Recession might be sufficient to drive short-term interest rates back to their effective lower bound.