The Federal Open Market Committee can gradually raise rates until reaching the neutral rate, currently 3%, Federal Reserve Bank of Chicago President Charles Evans said Thursday.
But he warned the low natural rate could be an issue in the future, when rates need to be cut. "In a world characterized by lower equilibrium interest rates, there is less room to reduce policy rates when, sometime in the future, the need will inevitably arise," Evans said in Chicago, according to prepared text released by the Fed.
"Accordingly, risk-management considerations point policy toward lowering the chance that policymakers again will face difficult [zero lower bound] outcomes in the future. This is an important reason why I favor taking a gradual path for the adjustment of the funds rate back toward its long-run level," he said.
In a low-trend-growth environment, short-term real interest rates are lower than normal. "At the moment, the assumption that the equilibrium, or neutral, real rate is as high as 1 percent may be optimistic," Evans said. "But let's go for now with that 1 percent number for the sake of discussion. Together, this value and the FOMC's symmetric 2 percent inflation target point to a nominal neutral federal funds rate of around 3 percent."
Real gross domestic product should grow between 2% and 2.5% in "the next couple of years, in part with the help of "expansionary fiscal policies," he said. Unemployment will drop to 4.25% by the end of 2019, below the 4.7% he considers the natural rate. "I think demographic factors will steadily lower this natural rate to about 4-1/2 percent by 2020. Therefore, I expect that under appropriate monetary policy the unemployment rate will undershoot the natural rate a bit over the medium term. Modestly undershooting the unemployment goal for a time will help boost inflation toward its target."
The fiscal policy changes expected from the Trump administration "is the main reason why I boosted my projection for growth in 2017 and 2018 by about 1/4 percentage point per year. My staff and I only made a modest change. It is early in the legislative process, and we need more details. Nevertheless, there certainly is a possibility of larger temporary stimulus, as well as some policies that might influence longer-run growth."
