By Frances Coppola
In the U.S., the Federal Reserve’s definition of “normal” depends on three key indicators—inflation, unemployment and real interest rates1 —which historically have been regarded as reliable guides to the state of the economy. When the economy is humming along, everyone is working productively and prices are stable, economists say it is “in equilibrium,” and the dollar’s exchange rate stabilizes at the level consistent with balanced trade and stable import prices. The rate of each indicator when the economy is in equilibrium is called the “neutral” or “natural” rate—i.e., normal.
In order to make monetary policy decisions, the Fed must be able to estimate the normal level for each indicator, which all come together in the Taylor rule equation (more on which later).
But in the decade since the Great Financial Crisis of 2007-8, it has become increasingly evident that the normal rate for each of the three indicators is in fact highly uncertain because the dynamic nature of the global economy is causing its underlying structure to evolve. So, the “normal” level of each indicator changes from time to time—and that’s not always obvious except in retrospect. What “normal” was prior to the crisis may not be “normal” in today’s turbulent world, as advancing technology changes markets and human behavior. Misreading these indicators may expose international businesses to unpredictable currency exchange rate risk.
Ever since the Great Financial Crisis of 2007-8, the Fed’s monetary policy has been “exceptional”—in other words, not normal. But from 2016 onwards, the Fed started “normalizing” policy, gradually raising interest rates. In 2018, the Fed accelerated the pace of normalization, raising interest rates four times and progressively shrinking its balance sheet, which had been inflated by three quantitative easing (QE) programs. This caused the dollar’s exchange rate to soar. Now, the Fed has suddenly paused interest rate rises. Could this mean the end of so-called normalization? Did the Fed misread “normal”?
Economic theory says that equilibrium is the natural state of the economy, but from time to time there are shocks that knock it out of equilibrium. When the economy is out of equilibrium, the Fed uses monetary policy to bring it back into equilibrium over the medium term.
The key equation that brings the Fed’s three principal indicators together is the Taylor rule equation, named after the economist John Taylor who devised it.2 By comparing current inflation (π or “pi”), GDP growth (economic output) and real interest rates (r) to estimates of what they would be in equilibrium, the Taylor rule equation calculates a setting for short-term interest rates that should, over time, bring the economy back into equilibrium.
The Taylor rule’s comparison of actual with potential economic output relies on the unemployment rate. This is because theory says an economy that is at its potential (or in equilibrium) deploys labor as productively as possible. High unemployment indicates that economic output is below potential, while unusually low unemployment can indicate the economy is overheating. Thus, the Taylor rule uses all three of the indicators.
In the equation, the neutral rate for each indicator is denoted by an asterisk, or “star.” Thus, the neutral rate of unemployment is u* (pronounced, u-star), the neutral rate of inflation is π* (pi-star), and the neutral real interest rates is r* (r-star). Fed Chairman Jerome Powell calls these the “lodestars” that guide Fed decision making.3
In the Taylor Rule equation, the neutral rate of inflation, pi-star, is defined as the Fed’s 2 percent inflation target.4 The inflation rate familiar to most people is the Consumer Price Index (CPI) inflation rate, which measures the general change in prices across a basket of typical consumer market purchases.5 But CPI inflation can vary considerably because the prices of some items in the basket, particularly foodstuffs and energy, depend on volatile world markets. For monetary policy purposes, therefore, the Fed uses a measure that excludes these items. This more stable inflation rate is the Personal Consumption Expenditure (PCE) rate. It is also known as “core” inflation.6 It is typically slightly lower than the CPI inflation rate. This can result in the Fed keeping interest rates low even when CPI inflation is rising due to world market conditions.
The unemployment rate that feeds into the Taylor Rule equation is defined as the percentage of the working-age population that is not working, is available for work, and is actively looking for work.7 The rate of unemployment, u-star, at which inflation does not rise determines potential output (GDP). It is more commonly known as the “non-accelerating inflation rate of unemployment” (NAIRU).8
The interest rate is the Federal Funds rate, which is the rate at which banks can borrow unsecured funds from each other overnight.9 This is a nominal rate, which means it includes the prevailing inflation rate. To obtain the real interest rate—the rate that banks really pay or receive after inflation is taken into account—the inflation rate must be deducted from the nominal interest rate. Thus, if the Fed sets the top of the Fed Funds rate range to 3 percent and inflation is running at the Fed’s target of 2 percent, the real interest rate is 1 percent.
The Taylor rule says that when inflation is lower than neutral (pi-star) and economic output is below the economy’s potential (i.e. unemployment is higher than neutral, or NAIRU), the Fed should set short-term real interest rates to a level higher than neutral (r-star). Conversely, when inflation is higher than neutral and unemployment is lower than neutral, real interest rates should be lower than their neutral rate. Lower interest rates stimulate the economy, raising both output and inflation, while higher interest rates calm inflation by reducing output.
Short-term interest rate changes influence the exchange rate by adjusting demand for dollar-denominated assets. When interest rates rise, demand for dollar-denominated assets increases, which increases demand for dollars and hence raises the exchange rate. Conversely, when interest rates fall, demand for dollar-denominated assets falls, reducing demand for dollars and hence putting downwards pressure on the exchange rate. Thus, by adjusting short-term interest rates, the Taylor rule helps the exchange rate to adjust towards its equilibrium level.
The Taylor rule relies upon there being credible estimates of the three stars. However, estimating the stars is not a perfect science. Powell has acknowledged that their values shift over time, for reasons that are not fully understood, and they can be far from where policymakers think they are.10
For much of the last decade, real interest rates have been well below what r-star was thought to be.11 However, the Fed’s recent interest rate rises,12 coupled with persistently low inflation,13 have brought the real short-term interest rate up off the floor. In December 2018, it was at around 0.5 percent. But the question now is whether r-star itself has changed. Is the “new normal” equilibrium interest rate permanently lower than it was before the crisis?
Many analysts now think that the values of all three stars have changed significantly since the financial crisis. For example, in a recent interview with CNBC, Federal Reserve Governor Lael Brainard said she thought that the “new normal” was a low r-star and a much less direct relationship between output and inflation than had previously been assumed14 —which may call the Taylor rule itself into question. A “new normal” for the stars that is significantly lower than in the past, as some have predicted,15 could mean a permanently lower exchange rate for the U.S. dollar.
Business’ FX risk becomes unpredictable, though, when no one actually knows for sure the neutral rates for these indicators!
As the financial crisis recedes into history, uncertainty about the indicators the Fed uses to set interest rates may be making the path of future interest rates unclear. For businesses, this can make it hard to plan for future financing costs and FX risk management. Subsequent pieces in this series will examine the changing relationship between unemployment, inflation and interest rates, and what this could mean for the three stars in the future.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Monetary Policy in a Changing Economy,” Jerome Powell, Federal Reserve; https://www.federalreserve.gov/newsevents/speech/files/powell20180824a.pdf
2. “Taylor Rule Utility,” Federal Reserve Bank of Atlanta; https://www.frbatlanta.org/cqer/research/taylor-rule.aspx
3. “Monetary Policy in a Changing Economy,” ibid.
4. “Taylor Rule Utility,” ibid.
5. “Consumer Price Index: Frequently Asked Questions,” U.S. Bureau of Labor Statistics; https://www.bls.gov/cpi/questions-and-answers.htm#Question_1
6. “Core inflation: calculation and economic impact,” The Balance; https://www.thebalance.com/core-inflation-rate-3305918
7. “How the Government measures unemployment,” U.S. Bureau of Labor Statistics; https://www.bls.gov/cps/cps_htgm.htm#unemployed
8. “Non-Accelerating Inflation Rate of Unemployment,” Investopedia; https://www.investopedia.com/terms/n/non-accelerating-rate-unemployment.asp
9. “Federal Funds Rate,” Investopedia; https://www.investopedia.com/terms/f/federalfundsrate.asp
10. “Monetary Policy in a Changing Economy,” ibid.
11. “Projecting the Long-Run Natural Rate of Interest,” Federal Reserve Bank of San Francisco; https://www.frbsf.org/economic-research/publications/economic-letter/2016/august/projecting-long-run-natural-rate-of-interest/
12. “Effective Federal Funds Rate,” FRED Economic Data; https://fred.stlouisfed.org/series/FEDFUNDS
13. “Personal Consumption Expenditures Excluding Food and Energy,” FRED Economic Data; https://fred.stlouisfed.org/series/PCEPILFE#0
14. “CNBC Exclusive: CNBC Transcript: Lael Brainard Speaks With CNBC’s Steve Liesman Today,” CNBC; https://www.cnbc.com/2019/02/14/cnbc-exclusive-cnbc-transcript-federal-reserve-governor-lael-brainard-speaks-with-cnbcs-steve-liesman-today.html
15. “Interest Rates and the ‘New Normal’,” John C. Williams, Federal Reserve Bank of San Francisco; https://www.frbsf.org/economic-research/publications/economic-letter/2017/october/interest-rates-and-the-new-normal-speech/