From an economic letter by Glenn Rudebusch, senior vice president and associate director of research at the Federal Reserve bank of San Francisco dated May 22 (H/T Greg Mankiw’s blog), emphasis FT Alphaville’s:
This dashed line shows that, in order to deliver a degree of future monetary stimulus that is consistent with its past behavior, the FOMC would have to reduce the funds rate to -5% by the end of this year—well below its lower bound of zero. Alternative specifications of empirical Taylor rules, described in Rudebusch (2006), also generally recommend a negative funds rate.
What Rudebusch is saying is that if the FOMC responds to unemployment and inflation rates as it has in the past, rates will have to go negative by the year’s end, according to current predictions. What’s more, as Rudebusch explains, the Fed has already proven itself pretty consistent in its methodology:
A rough guideline for setting the federal funds rate that captures the Fed’s behavior over the past two decades is provided by a simple equation that relates the funds rate to the inflation and unemployment rates.This equation is obtained by a statistical regression of the funds rate on the inflation rate and on the gap between the unemployment rate and the Congressional Budget Office’s estimate of the natural, or normal, rate of unemployment.
The resulting empirical policy rule of thumb—a so-called Taylor rule—recommends lowering the funds rate by 1.3 percentage points if core inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point.As shown in Figure 2, this simple rule of thumb captures the broad contours of policy over the past two decades.Differences between the recommended target rate from the estimated policy rule (the thin line) and the Fed’s actual target funds rate (the thick line) are fairly small.
Exceptions occurred during the mid-1990s and mid-2000s, when the funds rate was set somewhat higher or lower than the policy rule recommended.During 2007 and 2008, by this rudimentary empirical metric, the Fed’s lowering of the funds rate by over five percentage points was roughly in line with its historical behavior.Rudebusch also reminds the Fed has already stressed it is prepared to take exceedingly unconventional action if need be:
Still, with the economy continuing to slump, additional stimulus appears warranted, and the Federal Open Market Committee (FOMC 2009) has promised to “employ all available tools to promote economic recovery and to preserve price stability.”
Negative interest rates here we come?
Related links:
Negative interest in cash, or goodbye banknotes – FT Alphaville
More on Negative Interest Rates - Greg Mankiw’s blog