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By HaleStewart July 2, 2016 2:18 pm
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US Bond Market Week in Review: The St. Louis Fed Changes It's Interest Rate Decision Making Method

     This week, the St. Louis Federal Reserve announced a new regime to describe the U.S. economy and, as a direct result, the Fed’s interest rate policy.  It could mark a landmark change in Fed thinking. 

     The announcement begins by arguing the old method no long works:

The St. Louis Fed’s previous narrative emphasized eventual convergence to a single, long-run steady state. The output growth rate was consistently forecast to be above trend in the medium term, and the unemployment rate was forecast to decline. Inflation (net of commodity price effects) was forecast to return to and then exceed two percent over the medium term. The policy rate was forecast to eventually rise in order to be consistent with the single, long-run steady state.

The following chart represents the preceding paragraph:

The blue line shows potential GDP while the red line shows actual growth.  Before the 1990s actual growth almost always returned, more or less, to the same trajectory as potential growth.  But post-1990, the lines began to lose their correlation.  After the early 90’s recession, actual growth, while strong and in a clear upward trajectory, was below potential growth for a few years.  A slight deviation occurs after the early 2000s recession.  But after the “Great Recession” a clear deviation emerges.  This extreme deviation is most likely what caught the St. Louis Fed’s attention, forcing them to re-evaluate their methodology. 

     The bank offers the following difference between the old and new regime:

The St. Louis Fed’s previous narrative emphasized eventual convergence to a single, long-run steady state. The output growth rate was consistently forecast to be above trend in the medium term, and the unemployment rate was forecast to decline. Inflation (net of commodity price effects) was forecast to return to and then exceed two percent over the medium term. The policy rate was forecast to eventually rise in order to be consistent with the single, long-run steady state.

.....

The new narrative views medium- and longer-term macroeconomic outcomes in terms of a set of possible regimes that the economy may visit instead of a single, unique steady state. By doing this, we are backing off the idea that we have dogmatic certainty about where the U.S. economy is headed in the medium and longer run. We are trying to replace that certainty with a manageable expression of the uncertainty surrounding medium- and longer-run outcomes.  By doing so, we hope to provide a better description of the nature of the data dependence of monetary policy going forward.

The new model is best expressed by this diagram contained in the report:

In the new model, the Fed looks at three variables, beginning with the probability of a recession.  While the announcement does not explain the Fed’s criteria for determining the possibility, it’s probably safe to assume it’s a combination of yield curve analysis, Federal Reserve GDP projections and simple leading indicators.

     The use of the government debt’s return is an insightful choice, because it serves as a barometer of several key variables, starting with the public’s inflation expectations.  Government debt rates also show the public’s growth expectations, with relatively low rates indicating low growth expectations and higher relative levels signaling higher growth expectations.  The announcement also argues that current low rates relative to higher capital returns indicates the public is willing to pay a higher liquidity premium – another sign of weak growth expectations. 

     Finally, the Fed will look at the overall productivity level.  As a basic rule, low productivity equals lower growth while higher productivity equals higher growth.  Currently, the US is experiencing low productivity, which has attracted a fair amount of attention and concern from economists.  The Fed predicts a low productivity rate for the foreseeable future, which also retranslates into weak growth. 

     The report concludes by once again outlining the difference between the old and new regime:

The forecast values for output growth, inflation, and the unemployment rate in the new St. Louis Fed forecast are only somewhat different from those given under the previous narrative.  The main difference in the new approach is in the characterization of recommended future monetary policy via the forecast policy rate. In the previous narrative, we had a medium- and long-run outcome for the economy expressed in terms of a single, long-run steady state. In that formulation, all variables trended toward values that were consistent with the assumed long-run outcome. This includes the policy rate, which trended toward a value 350 basis points higher than it is today. If the Committee moved at a pace of 25 basis points per year, it would take 14 years to reach such a value.

In the new narrative, uncertainty about possible medium- and longer-run outcomes is more explicitly taken into account. The economy does not necessarily converge to a single steady state, but instead may visit many possible regimes. Regimes can be persistent, as we think the current one may be. The timing of a switch to an alternative regime is viewed as not forecastable, and so we simply forecast that the current regime will persist. Policy is regime dependent, leading to a recommended policy rate path which is essentially flat over the forecast horizon. Of course, the flat policy rate characterization is conditional on no switches occurring—if a switch does occur, then the policy rate would have to change appropriately.  This is a form of data dependence.

     Only time will tell if this new regime is effective.  But the tacit admission that the Fed must account for policy uncertainty in its projections is a needed and welcome change in its basic method of operating.

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