Former Federal Reserve Chairman Ben Bernanke explains the ongoing shift in the Fed’s economic views in his latest blog for The Brookings Institution.
“Over the past couple of years, [Federal Open Market Committee] participants have often signaled that they expected repeated increases in the federal funds rate as the economic recovery continued,” Bernanke writes. “In fact, the policy rate has been increased only once, in December 2015, and market participants now appear to expect few if any additional rate rises in coming quarters.”
While most commentary on FOMC decisions focuses on short-run factors, such as the uncertainty created by the recent Brexit vote, Bernanke explains that there’s more to it than just that.
“While [short-run] factors do affect the meeting-to-meeting timing of monetary policy decisions, they can’t account for extended deviations of policy from its expected path,” he writes. “The more fundamental reason for the shift in policy trajectory is the ongoing change in how most FOMC participants view the key parameters of the economy.”
To quantify changes in the thinking of FOMC participants, Bernanke looks at the views expressed by individual participants – specifically in the Fed’s Summary of Economic Projections. (Each quarter, individual FOMC participants — the Washington-based members of the Fed’s Board of Governors and all 12 of the regional Federal Reserve Bank presidents — submit their projections of how they expect certain key economic variables to evolve over the next 2-3 years and in the longer run.)
“Over the past few years, and especially during the past 12 months, FOMC participants have significantly revised down their estimates of potential long-run U.S. economic growth, the long-run or ‘natural’ rate of unemployment, and the long-run (‘terminal’) value of the federal funds rate — all of which are key determinants of economic performance,” Bernanke writes.
According to Bernanke, the declines in the past year have been particularly striking.
Based on the central tendencies submitted by FOMC participants, between June 2015 and June 2016 the typical participant marked down her estimates of both output and unemployment by 0.25 percentage points, while the median estimate of the fed funds rate dropped by 0.75 percentage points.
Cumulatively, over the past four years, Bernanke finds that estimated output has fallen 0.5 percentage points, estimated unemployment has declined 0.75 percentage points, and estimated fed funds rate has fallen by a substantial 1.25 percentage points.
According to Bernanke, the two changes in participants’ views that have been “most important in pushing the FOMC in a dovish direction” are the downward revisions in the estimates of the terminal funds rate and the natural unemployment rate.
“A lower value of the [fed funds rate] implies that current policy is not as expansionary as thought,” he writes. “With a shorter distance to travel to get to a neutral level of the funds rate, rate hikes are seen as less urgent even by those participants inclined to be hawkish.”
Likewise, the downward revisions in the estimated unemployment rate implies that bringing inflation up to the Fed’s target could take a “longer period of policy ease than previously believed,” Bernanke says.
While the FOMC participants’ views of how the economy is likely to evolve have not changed much, their views on the time it takes to evolve have likely changed.
“They still see monetary policy as stimulative … which should lead over time to output growing faster than potential, declining unemployment, and (as reduced economic slack puts upward pressure on wages and prices) a gradual return of inflation to the Committee’s 2% target,” Bernanke writes.
However, what the revisions in FOMC participants’ estimates of key parameters suggests is that they now see this process playing out over a longer timeframe than they previously thought.
“Relative to earlier estimates, they see current policy as less accommodative, the labor market as less tight, and inflationary pressures as more limited,” Bernanke writes. “The implications of these changes for policy are generally dovish, helping to explain the downward shifts in recent years in the Fed’s anticipated trajectory of rates.”
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