Kaplan explains why, despite imprecision, neutral rate remains useful

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While the neutral rate has its limitations, its concept is useful, Federal Reserve Bank of Dallas President Robert Kaplan wrote in an essay released Wednesday.

“Despite its inherent uncertainties, I believe that the neutral rate concept is a useful tool,” Kaplan wrote. Because of the problems in defining the neutral rate, he says, “it is best used in conjunction with a broad range of other economic analyses as well as extensive conversations with private sector leaders and a focus on identifying and differentiating between cyclical and structural drivers of the U.S. and global economies.”

The shortcomings of the neutral rate concept, include that estimates “are imprecise and uncertain, as are estimates of the natural rate of unemployment, potential GDP and other theoretical concepts we utilize to judge the state of the U.S. economy,” he wrote. “One key reason for uncertainty regarding estimates of the neutral rate is the difficulty in predicting future changes in the sustainable rate of productivity growth.”

But despite the inexact nature of the neutral rate, Fed officials “pay close attention to the various models that seek to estimate this rate” because the estimates “can provide an indication, albeit imperfect, of whether our monetary stance is accommodative, neutral or restrictive.” Kaplan wrote.

“The challenge for the Federal Reserve,” he noted, “is managing this process and getting the balance right.”

Kaplan said he is “hesitant” to rely on estimates of the shorter-run neutral rate, which are “more volatile and imprecise,” so he uses his appraisal of economic conditions.

Since monetary policy takes time to work, Kaplan noted, “policymakers have to make judgments on the stance and direction of policy well in advance. … keeping monetary policy accommodative for too long can lead to creation of excesses and imbalances that can be very difficult to address — and can create a need for the Federal Reserve to play ‘catch-up,’ which has historically increased the probability of recession. History has shown that some moderation can, in fact, increase the likelihood of extending an economic expansion.”

In addition to neutral rate estimates, Kaplan relies on discussions with business contacts, Fed “business surveys, assessments of labor market dynamics, inflation indicators, the behavior of various financial market indicators and the shape of the yield curve in assessing overall economic conditions.”

The Fed “is achieving its dual-mandate objectives,” Kaplan said, as the unemployment rate is about 3.7% and the headline personal consumption expenditures (PCE) estimates inflation slightly above 2%. As a result, he said, “I believe that the Federal Reserve should be gradually easing off the accelerator — we no longer need to be stimulating the U.S. economy. As such, I believe we should be gradually and patiently moving toward a neutral policy stance.”

The fiscal stimulus has boosted economic growth this year, Kaplan said, but it “is likely to wane somewhat in 2019 and further in 2020.” The rate of workforce growth, which he described as “a key driver of longer-term GDP growth,” will slow as the population ages.

The rate of productivity growth will determine future GDP growth, he said. “Because the sustainable rate of productivity growth is inherently difficult to predict, I have been somewhat cautious in my judgments regarding the appropriate pace and ultimate level of the federal funds rate.”

Kaplan said he uses the Treasury yield curve to guide him in making these assessments. “In my opinion, the one- and two-year short-term rates are substantially reflective of communications by the Federal Reserve regarding our expectations for the path of the federal funds rate,” he wrote.

Although his views may be altered by incoming economic data, Kaplan said, “My own estimate of the longer-run neutral rate is modestly below the median of the estimates made by my colleagues. My suggested rate path for 2019 is also modestly below the 3 to 3.25 percent median of the ranges suggested by my fellow FOMC participants. My [Summary of Economic Projections] estimates are consistent with my recent public statements which indicated that my base case for 2019 is to gradually and patiently raise the federal funds rate into a range of 2.5 to 2.75 percent or, more likely, into a range of 2.75 to 3 percent.”

He repeated his call for the Fed to move to a neutral stance, which he stated last week was two or three rate hikes away. “I intend to avoid prejudging what, if any, further actions we should take once we get into the range of our best estimate of a neutral stance,” he said. “I intend to make that judgment sometime in the spring or summer of 2019 based on the economic outlook at that time.”

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Monetary policy Robert Kaplan Federal Reserve Federal Reserve Bank of Dallas FOMC