Fed’s new take on neutral – Goldman Sachs

Research Team at Goldman Sachs, suggests that Fed officials have long argued that the neutral rate, or r*, has n been depressed by “headwinds”, legacies of the crisis that slow the economy’s recovery.

Key Quotes

“Recently, however, Fed officials have become sympathetic to the secular stagnation view that the factors depressing r* are instead longer-term and predate the cycle.

While the headwinds view implies that historical norms provide a useful guide to r*, the secular stagnation view instead implies that the current level of r* provides as good a guess as any about its future level. As a result, the shift in Fed thinking undermines a key motive for hiking—the desire to get “back to neutral” as the economy approaches full employment—and puts a greater onus on the data, especially the inflation data, to make the case for further tightening.

Using the Fed’s macroeconomic model, we show that the consequences of perceptions about r* are significant, even when they are wrong. While the impact on the economy of misestimating r* feeds back into the policy rule, the effect does not become fully offsetting for several years.

A large deviation from target inflation or unemployment would likely lead to a reassessment of r*. But under standard estimates of the Phillips curve, the inflation overshoot caused by underestimating r* would be moderate relative to the usual noise in the inflation data. While a steeper Phillips curve or less anchored inflation expectations would amplify the overshoot, overheating still might not be glaringly obvious in the inflation data for a long time. In contrast, the labor market is likely to send clearer and earlier signs of overheating.

While Fed officials have moved closer to the views of their dovish critics on r*, a key difference remains. The FOMC would likely react strongly to signs of labor market overheating, in part due to concerns about the difficulty of engineering a soft landing from below. The FOMC has long taken the view that risk management considerations are two-sided near full employment, and we therefore do not expect it to fully embrace its dovish critics’ policy conclusions.”