Monetary policy is close to a neutral level and the Fed needs to be cautious and patient about future rate hikes, Federal Reserve Bank of Kansas City President Esther George said Tuesday.
“While my policy view always depends on the flow of data, this year we must acknowledge that rates are approaching, and may be closing in on, our destination of neutral,” George said in a speech at the Central Exchange in Kansas City, according to prepared text released by the Fed.
“It is possible that some additional rate increases will be appropriate,” she said. “But making that judgment is not urgent and should depend on a careful look at the data and gathering additional insight into where our destination is, how much further we need to go to reach it and how quickly we should get there.”
The Fed, she said, can end its forward guidance, whereby it said policy was accommodative and it expected gradual interest rate hikes. “Given current economic conditions, providing such explicit guidance now about the future path of policy rates would not be appropriate in my view,” George said. “Back then, policy was some distance from a neutral setting and we had not fully realized our objectives for employment and inflation, and thus the direction of policy was clear.”
While the inflation outlook plays a major role in future policy decisions, George said past rate increases, which “have not yet fully played out,” suggest the need for patience in future policy actions. “Given the cumulative 225 basis points of tightening — 100 basis points of which occurred last year — we have likely not yet seen the full effect of higher rates on real economic activity or inflation. A pause in the normalization process would give us time to assess if the economy is responding as expected with a slowing of growth to a pace that is sustainable over the longer run.”
If the Fed moves too quickly, she said, it risks “an over-tightening of policy, a downturn in economic growth and an undershooting of our inflation objective.”
And with the neutral rate an estimate, not a number that can be pinned down, “these issues are made all the more difficult.” While the fed funds rate target sits at a range of 2.25% to 2.50%, the median estimate of the longer-run federal funds rate is 2.8%.
Furthermore, she noted that with balance sheet reduction, with the Fed letting maturing securities roll off, “it is unclear whether, or how much, this roll off is further removing accommodation. Again, this suggests it might be a good time to pause our interest rate normalization, study the incoming evidence and data, and verify our current location.”
Another factor suggesting patience would be wise, George said, “is that a number of key economic relationships that have guided policy over the years may have broken down in the aftermath of the financial crisis and Great Recession. Structural changes in the economy such as the aging of the population, sluggish productivity growth, business sector consolidation, rising government deficits and debt, and historically low interest rates have potentially rendered past guideposts to policy less reliable.”
And quantitative easing across the globe, and the ensuing need to now shrink balance sheets, “may be changing the structure of financial markets in unknown and unpredictable ways.”
A prime example is the unemployment rate being below its natural rate without a corresponding spike in inflation, she noted. “This raises questions about whether our estimate of the natural rate is too pessimistic and whether the economy can operate at a lower unemployment rate today than in the past without sparking inflationary pressures,” George said. “This is another area where I will be looking for feedback from the economy to assess whether we might need to revise our estimates of the natural rate.”
