Kaplan Looks Toward The Pause

Dallas Federal Reserve President Robert Kaplan had this to say about the neutral interest rate:

My own view, informed by the work of my colleagues Evan Koenig at the Dallas Fed as well as John Williams of the New York Fed and Thomas Laubach at the Federal Reserve Board, is that the longer-run neutral real rate of interest is in a broad range around 0.50 to 0.75 percent, or a nominal rate of roughly 2.50 to 2.75 percent.

With the current fed funds rate at 1.75 to 2 percent, it would take approximately three or four more federal funds rate increases of a quarter of a percent to get into the range of this estimated neutral level.

What should the Fed do when the Fed hits estimates of neutral? Kaplan would like to see the Fed pause:

At this stage, I believe the Federal Reserve should be gradually raising the fed funds rate until we reach this neutral level. 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.

This is an entirely reasonable approach as it acknowledges the existence of policy lags. It is very much possible that when the Fed hits the neutral rate, the impact of past tightening has yet to filter through much to the overall economy. Continuing blindly forward might then be a critical policy error if they have already tightened policy enough to ease growth down to a more sustainable level.

But can the Fed resist pressing forward if the data flow, particularly the jobs numbers, still suggest downward pressure on unemployment? I think that Powell & Co. could justify an extended pause on the basis of contained inflation and, more importantly, soft inflation expectations plus uncertainty about the natural rate of unemployment. Of course, if six to nine months from now core-PCE inflation is pressing up on 2.5% and wage growth is higher, the Fed would have a hard time waiving off ongoing strong job numbers.

The cleanest outcome is that economic activity moderates over the next six to nine months as the higher rates and tighter resource constraints bite. Housing, for example, is showing signs of moderating, particularly multifamily housing. A clear slowing of activity would go a long way toward helping the Fed shift toward an extended pause in the cycle. It would be realistic to consider the rate cycle to have peaked after 3 or 4 more 25bp points.

Bottom Line: For now, the Fed will stick with the policy of gradual rate rate hikes, almost certainly two more this year and one next. But the time is coming when going forward or standing still will not be an easy choice. The more dovish policy makers and those most worried about the yield curve are laying down the rational for standing still. It would be nice for permanent voting members of the FOMC need to start weighing in more on this debate.