Former Fed Chair Bernanke keeps a blog at Brookings. His latest post offers insight into how to think about Federal Reserve, and in particular, Fed officials’ understanding of the US economy.
Bernanke’s beginning point is the long-term forecasts of the Summary of Economic Projections–the last dots in the dot plot. There are three forecasts that are made, GDP, unemployment and Fed funds. The shorter-term forecasts are an assessment of where the economy is going in the current cycle, while the longer-term forecasts are more about structural relationships.
Bernanke argues that the long-term dot plot for GDP is a judgment about the potential growth. It is not within the control of monetary policy. In the long-run, it is about population growth and productivity. The long-term forecast for unemployment is an assessment of the “natural” rate or the non-inflationary level. It is a function of a variety of factor, including the number of workers, skill sets, and labor costs. The long-term forecast for Fed funds is the terminal rate or the neutral level. Besides inflation, Bernanke suggests the neutral level for Fed funds is influenced by the rate of return on capital and the supply of savings, for example.
There is a clear trend in the Fed’s thinking. The changes in the Fed’s views have been in the direction of lower potential growth, a lower ‘natural’ rate of unemployment and a lower neutral rate for Fed funds. Specifically, in the last four years, the long-term growth projection has fallen to 1.8%-2.0% from 2.3%-2.5%. The ‘natural’ rate of unemployment has fallen to 4.7%-5.0% from 5.2%-6.0%. The neutral rate of Fed funds has been cut from 4.25% from 3.0%.
Bernanke candidly admits what is behind the changes in the Fed’s thinking: persistent errors in economic forecasting. Productivity growth has slowed considerably. Also, Bernanke points out that the slower growth at the same time that unemployment has fallen faster than expected can be reconciled under Okun’s Law by less potential growth.
Low observed inflation and the decline in unemployment can be reconciled if the natural rate of unemployment is lower than previously understood. The lower equilibrium or terminal rate for Fed funds is, in part, a function of lower growth potential as it implies a lower return on capital. In turn, the lower equilibrium rate can also help explain the sluggishness of actual output growth, as it implies that current policy is not as stimulative as thought.
Bernanke also notes that Fed officials take into account the long-term interest rates that are set by the market. The low long-term may imply that investors anticipate an extended period of low real returns, low inflation (which means low nominal returns) and low-risk premiums on safe forms of debt. Together these suggest lower Federal funds rate in the long run.
There are two general takeaways from Bernanke’s commentary. First, the downward revisions to the long-term forecast imply that on balance, Fed officials see policy as less accommodative than previously, the labor markets are not as tight and price pressures more constrained. This speaks to a slower pace of normalization of US monetary policy. Second, Bernanke cautions Fe- watchers: They “should probably focus on incoming data and count a bit less on Fed policymakers for guidance.”