Academic journal article Federal Reserve Bank of St. Louis Review

Three Scenarios for Interest Rates in the Transition to Normalcy

Academic journal article Federal Reserve Bank of St. Louis Review

Three Scenarios for Interest Rates in the Transition to Normalcy

Article excerpt

During the fourth quarter of 2008, while in the process of rescuing a few large financial firms following the Lehman Brothers bankruptcy, the Federal Reserve added about $600 billion in excess reserves to the banking system. Throughout 2007, the banking system had operated with less than $5 billion. This action drove the interest rate on bank reserves (aka the federal funds rate or policy rate) below the Federal Open Market Committee's (FOMC) target rate of 2 percent. By the first Friday in December 2008, the effective federal funds rate had fallen to 12 basis points. On December 16, 2008, the FOMC then set the official federal funds rate target at a range of 0 to 0.25 percent, where it remains to this day. With the policy rate effectively at zero and the banking system flooded with excess reserves, the FOMC has tried to ease monetary conditions through two related policies: (i) forward guidance promises of maintaining the current policy rate even further into the future and (ii) large-scale purchases of long-term Treasury debt and agency mortgage-backed securities, which effectively exerts downward pressure on long-term interest rates. As of June 2014, this latter policy has increased the total of excess reserves to $2.6 trillion.

Within the Federal Reserve System, this situation is considered temporary and the FOMC is now debating strategies that would return both the balance sheet and the policy rate to normal. When the economy and monetary policy eventually return to normal, excess reserves would be expected to return to levels observed before the financial crisis. A useful definition of "normal" can be taken from the December 2014 FOMC long-run forecasts of real GDP growth (2.0 to 2.3 percent), inflation (2 percent), the unemployment rate (5.2 to 5.5 percent), and the policy rate (3.5 to 4.0 percent). (1) The effects of reducing excess reserves will depend on how interest rates change during the transition to normalcy. The level and volatility of interest rates will depend on the public's beliefs about future monetary policy. Carpenter et al. (2013) provide an excellent overview of the Fed's balance sheet and describe three exit strategies based on FOMC policy statements. Their projections of the Fed's balance sheet and its net income are conditioned on assumptions about future interest rates.

The "Lucas critique," a well-known econometric problem, is associated with simulating an economy under alternative policy assumptions (Lucas, 1976). The Carpenter et al. (2013) simulations are based on the implicit assumption that the U.S. economy has had one stable policy regime from about 1983 to the present and that the transition period will be an extension of this same policy regime. In this article, we discard this assumption and allow the periods with credibility, no credibility, and a zero policy rate to be separate regimes with different econometric properties.

Distinguishing between regimes is important because the major concerns surrounding the exit strategy for monetary policy arise from the interest rate implications of the transition to a separate policy regime. For example, in our judgment the "taper tantrum" of 2013 was a typical interest rate response that would naturally be associated with moving from a zero interest rate policy (ZIRP) to the credible monetary policy regime in place between 1983 and 2007, a period known as the Great Moderation. In addition, some economists and policymakers worry that the ZIRP regime will eventually lead to a loss of credibility for the Fed and a return to the high-inflation regime in the United States from about 1965 through 1979. (2)

Predicting interest rates during the transition to normalcy is complicated because it requires predicting the regime that will be in place at the end of the transition. How high interest rates are likely to rise and how likely the yield curve is to become inverted depends on people's beliefs about the policy regime. …

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