The Federal Open Market Committee will have to raise the fed funds target rate three or four times from its current range of 1.75% to 2% to hit the neutral rate, where monetary policy is neither accommodative nor restrictive, according to Federal Reserve Bank of Dallas President Rob Kaplan.
“At this stage, I believe the Federal Reserve should be gradually raising the fed funds rate until we reach this neutral level,” Kaplan wrote in an essay posted on the Bank’s website Tuesday. “At that point, I would be inclined to step back and assess the outlook for the economy and look at a range of other factors — including the levels and shape of the Treasury yield curve — before deciding what further actions, if any, might be appropriate.”
The Fed has reached its dual objective — full employment and price stability — and “as such, we should be removing accommodation in a gradual manner in order to get to a neutral policy stance,” Kaplan wrote.
While the neutral rate “is a theoretical concept, meaning that it can’t be directly observed — it must be inferred from market and other economic data,” Kaplan said, it is “critical to assessing and making decisions regarding the stance of monetary policy.”
Kaplan believes “the longer-run neutral real rate of interest is in a broad range around 0.50% to 0.75%, or a nominal rate of roughly 2.50% to 2.75%.”
The Fed’s job, he said, is to raise rates slowly enough that the expansion continues, yet quickly enough so as not to “get behind the curve so that we have to play catch-up and raise rates quickly. Having to raise rates quickly would likely increase the risk of recession.”
But, Kaplan noted, he will keep an eye on the yield curve. “As I judge the pace at which we should be raising the federal funds rate, I will be carefully watching the U.S. Treasury yield curve.” The short-end, he believes, “is responding to Federal Reserve policy expectations. The longer end of the curve is telling me that, while there is substantial global liquidity and a search for safe assets, expectations for future growth are sluggish — and this is consistent with an expectation that U.S. growth will trend back down to potential.”
The flattening of the curve “suggests to me we are ‘late’ in the economic cycle. I do not discount the significance of an inverted yield curve — I believe it is worth paying attention to given the high historical correlation between inversions and recession.”
The global economy also needs close monitoring. He said, “[G]lobal economic and financial instability has the potential to transmit to domestic financial markets, potentially leading to a tightening of financial conditions which, if prolonged, could lead to a slowing in U.S. economic activity.”
Kaplan does not have a vote on the Federal Open Market Committee this year.
