Ben Bernanke, Chairman of the US Federal Reserve, is arguably the most important economist in the world. While fiscal policy in the US lurches from one fiscal cliff crisis to the next sequester crisis, US monetary policy has been calmly and methodically venturing into unconventional areas to spur the economy. Apart from Japan’s experience with quantitative easing (QE), there is little historical precedence to guide our knowledge of unconventional monetary policy. Luckily, however, there has been a lot of theoretical work , so the Federal Reserve has a lot of academic work to guide its policy decisions.
In light of this, Bernanke has just given a talk about Federal Reserve policy. As the short term interest rate is essentially at zero, he focused his discussion on long term interest rates. He laid out the determinants of these rates and addressed the concerns about the long run picture for these rates and financial stability. According to Jeremy Stein, a Federal Reserve colleague of Bernanke’s, there is currently a reach for yield in the financial sector that risks future instability. Stein, consequently, called for an early increase in the interest rate, but Bernanke does not agree, as he explained in his speech.
What are the determinants of long term interest rates?
To explain long term rates, Bernanke decomposed these rates into three determinants: expected inflation, the expected path of short term real interest rates, and a term premium. The historical path for these determinants is shown in the figure below, as devised from a term structure model at the Federal Reserve. With expected inflation remaining pretty stable, most of the negative trend in long term rates has come from lower expectations of real short rates and the term premium. In terms of short rates, Bernanke notes that this is in part due to revised expectations about the slow recovery, which pushes out expectations of how long short term nominal rates will remain low.
Should we be concerned about the unwinding of QE?
The short answer is no. To help us answer this question, we can look at each of the determinants of long term rates in turn. Regarding inflation expectations, Bernanke assumes that these will stay anchored around 2% and I can’t see any reason that this anchor would suddenly fail. The term premium is expected to return to more normal levels in the coming years, which pushes up rates slightly. Most importantly, the expected path of short term real rates should rise gradually in the next several years as the modest recovery continues and unemployment declines slowly. The expectations of short term nominal rates will be affected by the market’s view of this recovery and the expected timing of a return to more normal interest rate levels. With the Fed’s improved transparency and communication strategies, I would assume that the unwinding of the stimulus and return to normal of interest rates can be managed in a controlled way.
Gavyn Davies & the Bank for International Settlements (BIS)
To further support this, Gavyn Davies in his FT blog cites some fascinating work from the BIS. The work relates to the crucial concept of the ‘output gap’ in macroeconomic policymaking. This gap refers to the difference between what the economy is currently producing and what it could produce if all factors of production were working to their potential. This is notoriously hard to measure, but it is central to decisions about how much stimulus can be applied to an economy without risking a surge in inflation.
The issue is, or should I say was, that the concept of the output gap did not take into account financial market imbalances or imperfections. This meant that policymakers did not place enough emphasis on the rise in house prices and the build of credit and leverage in the private sector. The BIS, therefore, have devised a ‘Finance Neutral Output Gap’ that not only takes into account the gap in the real economy, but it adjusts for financial variables as well.
The result of this first pass are seen in the chart below for the US economy over the last decade. On the left is the traditional output gap. Importantly, it shows that the overheating in the economy was not captured by this measure in real time, only with revisions from latest data. Conversely, the finance neutral output gap would have been able to detect this overheating in real time.
What does the Finance Neutral Output gap say about today?
Both the ex-post and real time estimates of this gap show that the US economy is well under its potential level of production, even after taking into account the financial sector. This supports Bernanke’s view of current climate, rather than that of Stein’s.
The future: Managing the Business Cycle of the Financial Sector?
Looking ahead to the future of central bank policymaking and accompanying research, it will be terribly interesting to see the attention given and balance struck between the real economy and the financial sector. Policymakers will need to understand all of the tools at their disposal, from interest rates, to expectation management and macro-prudential policy tools. They will also need to understand, in real time, where the risks in the economy are. That is, in which sector is the concern? Who are the main players in this risk scenario? It will then be a challenging task to match the policy tool to the risk. After the biggest financial meltdown since the Great Depression, the future of policymaking will be much more complicated, but much more interesting as well.