The decision by the US Federal Reserve to leave monetary policy unchanged at the recent FOMC meeting was interesting on a number of fronts, including the emphasis given to the global situation in informing the outcome. OF more significance was the economic forecasts supplied by the 17 Fed members in confirming a trend evident for some time- the US Central Bank, like other policy makers across the world, has become increasingly gloomy about the medium term outlook for growth, and as a corollary expects interest rates to remain much lower than generally seen in the post-war era. That view has been around markets and academia for a while but it now seems to have permeated official thinking in a serious way.
Secular Stagnation is the thesis that growth in the medium term will be weaker than we have become accustomed to, certainly in the developed world and possibly also in many parts of the developing world. Labour force growth has slowed in the West and in some cases is already falling, which reduces potential GDP growth, but a feature of the stagnation view is an emphasis on the savings/ investment balance. Ben Bernanke was one of the more prominent economists drawing attention to global excess savings, which he saw as putting downward pressure on interest rates and sought to link this to the observed trend decline in longer term bond yields in the US, the closest approximation to a global risk free rate of interest. More recently, others have drawn attention to investment spending, which is weak by historical standards, which is put down to a number of factors, including changing technology ( the capital spending generated by the internet versus railways or electricity for example) or simply a perceived decline by companies in profitable investment opportunities. Capital spending by governments, once the mainstay of Keynesian expansionary fiscal policy, has also fallen foul of the new orthodoxy , which extolls retrenchment.
The result of this combination of higher savings and lower investment demand is a decline in the equilibrium real rate of interest. Indeed, some argue, like Larry Summers, that the equilibrium real rate may now be negative. With nominal rates now at the zero bound the only way to get negative real rates is to generate some inflation but so far policy makers have not succeeded in that aim, with inflation closer to zero than to official targets in many economies. Indeed, with deflation in some cases, real rates are positive.
Given that background it is interesting to observe the evolution of the Fed’s thinking over the past few years. The long term rate of US GDP growth, which used to be thought of as around 2.7%, is now put at only 2% in the latest Fed projections, although that is still deemed consistent with inflation picking up to the 2% target. The forecast Fed funds rate ( the Dot Plot) in the long term has also fallen, to 3.5% from around 4% a few years ago, which implies a 1.5% equilibrium real Fed Funds rate( 3.5% nominal less 2% inflation).
The Fed’s view on the timing in reaching this target has also changed appreciably; a year ago the median expectation was a Fed Funds rate of 1.375% by the end of 2015 and that is now 0.375% (with only two meetings remaining this year). Similarly, the current median expectation for official rates at end-16 is 1.375% against 2.875% twelve months ago. What is also striking is the distribution of the forecasts for next year, with a range of -0.125% to 2.875%.
Equity markets did not react well to the FOMC leaving rates on hold, which implies that it is the Fed’s nervousness about the short-term outlook that is dampening investor spirits, offsetting any positives from the absence of tightening. The Fed’s gloomier longer term view is perhaps more significant , however, in that we are all Secular Stagnationists now it would seem.