If you had told any economist back in the 1980s that the Federal Reserve’s benchmark interest rate, adjusted for inflation, would be negative or zero for a decade without producing significant imbalances in the economy, he would have said you were nuts.
And yet, here we are, almost 10 years since the Fed slashed the nominal federal funds rate to a range of 0% to 0.25% during the depths of the financial crisis and Great Recession, and the real funds rate is still close to zero.
How can we explain the coexistence of today’s strong economy (expanding at a rate above what is believed to be its long-run potential), stable inflation near the Fed’s 2% target, and a 0% real funds rate? Going forward, will the U.S.’s $20.4 trillion economy, the largest in the world, require such low rates to produce the equivalent of the past decade’s unspectacular economic growth?
Several explanations come to mind, none of which is entirely satisfying, that may offer different ways of looking at the situation.
1. In transition
For starters, the real funds rate is at zero — en route to something positive. At least that’s the Fed’s intention, as laid out in its quarterly Summary of Economic Projections in September.
The SEP implies that the Fed will have to step on the brakes — run a restrictive policy to slow the economy’s momentum — in 2020 and 2021, raising the funds rate to 3.4%, which is above the projected long-run neutral rate of 3%.
The recent rise in long-term rates is being driven by real yields, a sign that investors anticipate stronger economic growth, not by rising inflation expectations. To-date estimates for third-quarter real gross domestic product growth are close to the second quarter’s 4.2%. So the zero-real-rate train may be getting ready to leave the station.
2. Waiting in the wings
In most instances, it takes less than a year after a recession ends for the economy to recover lost output and exceed its pre-recession peak, as measured by the level of real GDP. Following the long and deep 2007-2009 downturn, however, real GDP didn’t take out its 2007 peak until the second quarter of 2011.
In other words, there was lots of slack to be reutilized. The economy lumbered along at a 2.1% pace through the end of 2016, slightly faster than what the Fed and Congressional Budget Office consider to be its long-run potential.
The pace has picked up since President Donald J. Trump took office in January 2017, averaging 2.7% in the first six quarters of his administration. Wages have been slow to respond to worker shortages.The Fed’s Phillips Curve model is in the shop for retooling. Trade-war tariffs will eventually raise consumer prices. In other words, just when policy makers have been lulled into the belief that inflation is a relic of past business cycles, it could rear its head once again.
3. The first shall be last
Housing has been one of the reliable leaders of an economic recovery because of its sensitivity to interest rates.
Not this time. Not when a housing bust and the financing that underwrote the boom were the key drivers of the financial crisis.
“There was a structural change,” said Jim Glassman, head economist at Chase Commercial Bank. “Rather than charging out of the gate, the real-estate sector was the slowest to recover, despite extremely low rates.”
Household formation slowed as young people dropped out of the workforce, moved in with their parents and went back to school, he said.
The homeownership rate in the U.S. declined from 68.2% to a low of 62.9% in 2016. The rate stood at 64.3% in the second quarter of 2018.
The number of single-family housing starts and new home sales is still less than half its pace at the 2005 peak at a time when the residential real estate market is showing signs of a slowdown.
Absent its traditional leader to ignite the recovery and drive the expansion, the economy needed more help from the Fed. In other words, the Fed had to hold interest rates lower for longer to get a similar result as in past business cycles.
4. Been there, done that
What may seem like abnormally low interest rates for an extended period isn’t really abnormal, according to David Beckworth, senior research fellow at George Mason University’s Mercatus Center. “From the Great Depression to the late 1940s, the U.S. had very low short-term rates as well.” (While short-term Treasury bill rates hovered near zero from the early 1930s through 1948, the decline in consumer prices in 1930, 1931 and 1932 translated into higher real rates.)
The current extended period of low rates suggests to Beckworth that the Fed’s policy rate was actually above the unobservable natural, or neutral, rate for a long time — even when that rate was close to zero. If the funds rate was above the natural rate, then it was well above where it needed to be to provide stimulus during a steep downturn. Which is why the Fed resorted to long-term asset purchases.
To the extent that the response to the Great Recession was “a high level of risk aversion” on the part of households and businesses, aided and abetted by new regulation and capital requirements, it’s not hard to understand why rates have been lower for longer than anyone imagined, Beckworth said.
5. The new normal grows old
If there is a free lunch in this world, it is productivity growth. The ability to produce more (output) with less (labor input) drives investment, lowers costs and raises real wages. Productivity and labor-force growth determine how fast an economy can expand without inducing inflationary pressure.
The problem right now is that nonfarm business productivity growth has been stuck in a rut since 2004. Even manufacturing productivity is underperforming compared with prior business cycles. And while the recent pick-up in business fixed investment is encouraging, it is too early to declare a trend change — even if productivity is everywhere apparent except in the data!
Unless productivity growth picks up or the U.S. admits a lot of skilled immigrants to offset the retiring baby boomers, which seems unlikely, low interest rates, at least relative to past experience, may turn out to be the new normal.
