A Patient Fed, and Monetary Non-Neutrality
Federal Reserve Chairman Jerome Powell said Tuesday that the central bank will take a “patient approach” in considering future rate hikes. In hearings with the Senate banking committee, he said that muted inflation “gives us the ability to be patient with monetary policy and that’s what we’re going to do.” Recent research suggests that Fed announcements affect beliefs not only about monetary policy but also about other economic fundamentals. With recent criticisms of the Fed coming from the President and Bridgewater Associates founder Ray Dalio among others, it is increasingly important to understand additional ways the Federal Reserve can influence the direction of the economy.
It has historically been difficult for macroeconomists to isolate the effects of monetary policy on foundational variables. This is because actions by the Fed are frequently in response to adverse economic shocks. While many economists have made significant efforts to control for important confounding variables, some bias has remained. A recent paper, published in the Quarterly Journal of Economics by Nakamura and Steinsson focuses on movements in bond prices in the 30 minutes around Federal Open Market Committee meetings. The idea behind this approach is that all public information at the beginning of the 30 minute window is already incorporated into financial markets and will not confound effects from new announcements.
Under conventional interpretation of monetary policy, a policy-induced increase in real interest rates leads to a drop in output. This is because the cost of borrowing and incentives to save for individuals and corporations are increased. However, Nakamura and Steinsson documented survey estimates of expected output growth rise following unexpected increases in the real interest rate, an effect in the opposite direction from conventional interpretations. This suggests that announcements at the Federal Open Market Committee meetings lead the private sector to reconsider their assessments of the economic outlook.
Additionally, they used moments of responses to real interest rates, expected inflation and expected growth output and found that around 2/3 of the response of real interest rates are estimated to be a response of the natural rate of interest while only 1/3 was a tightening of real rates relative to the natural rate. The natural rate of interest is the rate consistent with real GDP reaching its potential, so changes to the natural rate of interest rate indicate fundamental changes to beliefs about the economy. As this additional power for the Fed to influence the direction of the economy is increasingly understood, we should see the Fed learn to better wield the tool to avoid disruption like what was observed in the fourth quarter of 2018.
SOURCES:
“Patient Approach” – USA TODAY
High Frequency Identification of Monetary Non-Neutrality – Quarterly Journal of Economics