from the San Francisco Fed

— this post authored by John C. Williams

The Federal Reserve is moving towards more normal monetary policy, which means rising interest rates. But factors including the real natural rate of interest, a slower sustainable pace of growth, and inflation all point to a new normal where interest rates are lower than in the 1990s and early 2000s.

The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco to the Community Banking in the 21st Century Research and Policy Conference in St. Louis on October 5.

Today I’m going to talk about interest rates…in a lot of detail…so I hope you all got yourselves an extra large cup of coffee before you found your seats this morning.

Why am I talking about interest rates? First, as President of the San Francisco Fed it’s a favorite subject of mine! Second, there are a lot of misperceptions out there about what’s going to happen to interest rates, when they’ll rise and by how much. As bankers, interest rates play a pivotal role in your lives, so I thought that you might appreciate a deeper dive into the current thinking.

I frequently hear people say, “as things return to normal, and rates rise, we’ll be able to do A, B, or C.” It’s true that, post-financial crisis, things are returning to normal. But normal may look and feel quite a bit different from what you’re used to, so I want to talk about this “new normal.”

First, the good news: The economy is growing at a moderate pace. In fact, we’re now in the ninth year of the expansion. As a result of the progress we’ve made getting our economy back on track, we’re in the process of slowly moving interest rates back up to more normal levels. But what does “normal” mean?

I know that for many in finance the word normal conjures memories of the ’90s, when interest rates were often above 4%. But like the pager, the Walkman, and the Macarena, we’re unlikely to see such rates return. Bottom line: In the new world of moderate economic growth, banks need to plan for lower rates.

Why is this? To explain why, I’m going to talk a bit about something called r-star, which is shorthand for normal interest rates. Then I’m going to talk a bit about growth, a bit about inflation, and discuss some interesting factors behind why inflation’s remained stubbornly low (despite strong employment). Finally, I’m going to switch tacks and talk about the Fed balance sheet and what it means for longer-term rates.

Please pay attention, because I’m looking forward to a lively discussion afterwards about the new normal and what that means for community banking.

R-star

With that road map in mind, let’s dive into r-star. R-star is what economists call the natural rate of interest; it’s the rate expected to prevail when the economy is at full strength, and it’s a helpful way to understand the new normal both in the short and longer term. While a central bank like the Fed sets short-term interest rates, r-star is a result of structural economic factors beyond the influence of central banks and monetary policy.

My own view is that r-star today is around 0.5%. Assuming inflation is running at our goal of 2% in the future, the typical, or normal short-term interest rate would be 2.5%. That’s a full 2 percentage points below what a normal interest rate looked like 20 years ago. For comparison, the median longer-run value of the federal funds rate in the Federal Open Market Committee’s (FOMC) most recent economic projections is 2.75% (Board of Governors 2017b). We’ve seen this trend across other major economies: Average r-star across Canada, the euro area, Japan, and the United Kingdom is a bit below 0.5% (Holston, Laubach, and Williams 2017; Fujiwara et al. 2016).