With gradual tightening continuing, monetary policy will become slightly restrictive as the neutral rate remains low, Federal Reserve Board Gov. Lael Brainard said Thursday.
“This outlook suggests a policy path that moves gradually from modestly accommodative today to neutral — and, after some time, modestly beyond neutral — against the backdrop of a longer run neutral rate that is likely to remain low by historical standards,” Brainard said in remarks prepared for delivery in New York, released by the Fed.
While the neutral rate should rise over the medium term, but her long-term outlook for the neutral rate remains. “I expect current tailwinds to boost the neutral rate gradually over the medium term but leave little imprint on the long-run neutral rate,” she said.
“I continue to view gradual increases in the federal funds rate as the appropriate path,” Brainard added, “although I will remain vigilant for the emergence of risks and prepared to adjust if conditions change.”
GDP growth will gain speed in the coming quarters, she predicted, based on consumer spending and business investment. “Moreover, the sizable fiscal stimulus that is in train is likely to provide a tailwind to growth in the second half of the year and beyond,” she said.
While the jobs market, rising inflation, and fiscal stimulus suggest upside risks, Brainard warned of downside risks posed by global issues. “Political developments in Italy have reintroduced some risk, and financial conditions in the euro area have worsened somewhat in response,” Brainard noted. “With some uptick in political uncertainty, and inflation still below target in the euro area and Japan, monetary policies among the advanced economies look likely to be divergent for some time. In addition, some emerging markets may find conditions more challenging.”
Discussing the flattening yield curve, Brainard offered several explanations including “unusually low” long-term interest rate expectations, falling term premium. “Other things being equal, a smaller term premium will make the yield curve flatter by lowering the long end of the curve,” she said. “With the term premium today very low by historical standards, this may temper somewhat the conclusions that we can draw from a pattern that we have seen historically in periods with a higher term premium. With a very low term premium, any given amount of monetary policy tightening will lead to an inversion sooner so that even a modest tightening that might not have led to an inversion in the past could do so today.”
If the Federal Open Market Committee’s expectations from its Summary of Economic Projections come to fruition, the yield curve may invert, but “if the term premium remains low by historical standards, there would probably be less adverse signal from any given yield curve spread.”
She continued, “So while I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.”
Brainard also noted the forward-guidance language in the post-meeting statements that the fed funds rate is likely to remain below its long-run levels “is growing stale and may no longer serve its original purpose.”