Trade knowledge / Upcoming Challenges for Federal Reserve Policy
Date: 2016-09-05
Upcoming Challenges for Federal Reserve Policy
Central banks are responsible for determining the monetary policy by setting the interest rates to balance investments and savings, which helps to keep economies fully employed and inflation stable. The natural rate is the interest rate that helps to achieve the balance, and federal reserve policy makers believe that the rate is at 3%, down from 4.5% prior to the recession. The 1.5 percentage point decline in the natural interest rate provides less ability to counteract future economic shocks.
It was initially thought that the natural rate’s decrease was transitory due consumers and companies paying down debt or borrowing less after the last recession. As time passes, it has become apparent that are other factors influencing the drop in the natural rate, such as a decrease in productivity growth, rising inequality, and risk aversion that has increased the demand for government bonds. Policy makers are considering accepting the current the status quo, fixing underlying growth, and changing the inflation target to respond to the new normal; however, each has its own drawbacks.
Accepting the status quo would mean that the slowdown in growth may be temporary or that the economy has changed in a way that would make recessions in the future less severe. The Federal Reserve has used unconventional tools, like purchasing government bonds by creating money or committing to keep rates at zero, to help bolster the economic growth. David Reifschneider, a Federal Reserve economist, calculated that the Federal Reserve can make up for the inability of rates to go further lower by employing the same tools should there be another downturn.
The second option would be to fix the underlying slow growth by using deficit–financed government infrastructure, which would raise public investment and provide incentives for private investment. The Federal Reserve would not be directly involved, but along with the Treasury, it would buy the bonds that finance the infrastructure development, which is a form of stimulus more commonly called “helicopter money”. To allow for the best affect, countries globally would have to expand their deficits; and if the United States was the only country to do so, interest rates and the strength of the dollar would increase, increasing the amount of imports and decreasing the benefit of the “helicopter money”.
The third option would be to change the 2% inflation target to a higher inflation target, such as 3% or 4%. The 2% inflation target was established to minimize the inflationary boom cycles between 1966 and 1982 and the inefficiencies caused by the constantly changing prices. A higher average inflation target would imply a higher natural rate, which would provide more leeway for possible future easing without using tools like quantitative easing.
Another challenge for the Federal Reserve is the need to overcome a demographic hurdle, as millennials don’t expect inflation to cause prices to increase. Those who entered the workforce after 2000 have experienced an inflation with the core Personal Consumption Expenditure (PCE) price inflation averaging 1.7%, which is below the federal reserve’s 2% target; both of which are relatively low compared to the 4.3% annual core PCE growth between 1965 and 2000.
The hurdle exists in that the Federal Reserve must keep inflation expectations high, but the millennial generation actively values things which tend to act as deflationary forces, such as technology, subsidized education, and healthcare. According to research done by Nick Colas, chief market strategist at the brokerage firm Convergex Group LLC, millennials view declining prices for consumers as a sign of healthiness, and the new technologically driven services economy places downward pressure on daily expenses by reducing inefficiencies and increasing affordability.
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