Fed Reserve Governor Lael Brainard: Growing above Trend, Sustaining Full Employment and Inflation around Target

There are a number of possible explanations of the low level of the term premium. The asset purchases of the Federal Reserve and other central banks may be contributing factors. The goal of these policies was to lower longer-term interest rates--and in many cases, expressly by lowering term premiums. A number of studies suggest that these polices have indeed been successful in lowering term premiums.10

A second reason the term premium may be lower than in the past is the changing correlation between stock and bond returns, likely caused by changes in expected inflation outcomes.11 While in the 1970s and 1980s stock and bond returns tended to be positively correlated, more recently the correlation has tended to be negative. With an inverse correlation, bonds recently have been a good hedge for stocks, and that correlation may have contributed to lower bond term premiums by increasing the demand for bonds as an instrument for hedging portfolio risks. This changed correlation between stock and bond returns in turn may be related to better anchored inflation expectations following a long period of low and stable inflation.

Looking ahead, it seems likely the term premium will increase somewhat, although perhaps not to the levels seen historically. On the one hand, a continued gradual runoff of the balance sheet of the Federal Reserve and reduced bond buying by other central banks will tend to put upward pressure on the term premium. On the other hand, the FOMC's demonstrated commitment to maintaining low and stable inflation makes it unlikely that expectations of high inflation will reemerge. Thus, on balance, while term premiums may recover somewhat from their recent depressed values, it is unlikely they will return to the high levels of earlier decades.

The Path of Policy
In the median outlook in the FOMC's Summary of Economic Projections (SEP), the federal funds rate is projected to reach its longer-run value by 2019 and exceed it in 2020. If the 10-year term premium were to stay very low, that path would likely imply a yield curve inversion. But for the reasons I just noted, if the term premium remains low by historical standards, there would probably be less adverse signal from any given yield curve spread.

It is important to emphasize that the flattening yield curve suggested by the SEP median is associated with a policy path calibrated to sustain full employment and inflation around target. So while I will keep a close watch on the yield curve as an important signal on how tight financial conditions are becoming, I consider it as just one among several important indicators. Yield curve movements will need to be interpreted within the broader context of financial conditions and the outlook and will be one of many considerations informing my assessment of appropriate policy.

As suggested by the SEP median path, I believe that the forward-guidance language in the Committee statement that was introduced a few years ago that "the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run" is growing stale and may no longer serve its original purpose. For purposes of comparison, in March 2016, the median of SEP projections for the federal funds rate path had the funds rate rising to 3.0 percent and remaining below the longer run value that was projected to be 3.3 percent. A year later, the median projection of the longer-run federal funds rate fell. In the March 2018 SEP, the median projection of the federal funds rate peaks at 3.4 percent in 2020--1/2 percentage point above the median projection of its longer-run value of 2.9 percent. It is worth noting that this progression reflects a decrease in the long-run federal funds rate as much as an increase in the medium-run federal funds rate.

Conclusion
In an environment of tightening resource utilization and above-trend growth, with sizable fiscal stimulus likely to provide a boost to demand in the near-to-medium term that should fade somewhat further out, it seems likely that the neutral rate could rise in the medium term above its longer-run value. I expect current tailwinds to boost the neutral rate gradually over the medium term but leave little imprint on the long-run neutral rate. The short-run level of the neutral rate should rise gradually because the forces that are moving the economy from headwinds to tailwinds are likely to play out gradually. Although the tax cuts are already in place, their effects may not be fully felt for a few years, and the spend-out from the recent budget agreement may occur with some delay. A gradual pace is also warranted in light of the long period of undershooting the inflation target.

I would not underestimate the challenge of calibrating monetary policy to sustain full employment and re-anchor trend inflation around 2 percent, while adjusting to sizable stimulus at a time when resource constraints are tightening and the economy is growing above trend. I continue to view gradual increases in the federal funds rate as the appropriate path, although I will remain vigilant for the emergence of risks and prepared to adjust if conditions change.

References
Bauer, Michael D., and Thomas M. Mertens (2018). "Economic Forecasts with the Yield Curve," FRBSF Economic Letter 2018-07. San Francisco: Federal Reserve Bank of San Francisco, March.

Board of Governors of the Federal Reserve System (2018). "Federal Open Market Committee Reaffirms Its 'Statement on Longer-Run Goals and Monetary Policy Strategy,' " press release, January 31.

Brainard, Lael (2015). "Normalizing Monetary Policy When the Neutral Interest Rate Is Low," speech delivered at the Stanford Institute for Economic Policy Research, Stanford, Calif., December 1.

-------- (2016). "The 'New Normal' and What It Means for Monetary Policy," speech delivered at the Chicago Council on Global Affairs, Chicago, September 12.

-------- (2017). "Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate," speech delivered at the Economic Club of New York, New York, September 5.

-------- (2018). "Navigating Monetary Policy as Headwinds Shift to Tailwinds," speech delivered to the Money Marketeers of New York University, New York, March 6.

Chen, Andrew, Eric Engstrom, and Olesya Grishchenko (2016). "Has the Inflation Risk Premium Fallen? Is It Now Negative?" FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4.

Congressional Budget Office (2018). The Budget and Economic Outlook: 2018 to 2028 (PDF).Washington: CBO, April 9.

Estrella, Arturo, and Frederic S. Mishkin (1997). "The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank," European Economic Review, vol. 41 (July), pp. 1375‑401.

Favara, Giovanni, Simon Gilchrist, Kurt F. Lewis, and Egon Zakrajsek (2016). "Recession Risk and the Excess Bond Premium," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 8.

International Monetary Fund (2018). World Economic Outlook Update: Brighter Prospects, Optimistic Markets, Challenges Ahead. Washington: IMF, January.

Johansson, Peter, and Andrew Meldrum (2018). "Predicting Recession Probabilities Using the Slope of the Yield Curve," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, March 1.

Kiley, Michael T., and John M. Roberts (2017). "Monetary Policy in a Low Interest Rate World (PDF)," Brookings Papers on Economic Activity, Spring, pp. 317-96.

Kim, Don H., and Jonathan H. Wright (2005). "An Arbitrage-Free Three-Factor Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates (PDF)," Finance and Economics Discussion Series 2005-33. Washington: Board of Governors of the Federal Reserve System, September (revised December 2011).

Li, Canlin, and Min Wei (2013). "Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Programs (PDF)," International Journal of Central Banking, vol. 9 (March), pp. 3-39.

Nakata, Taisuke, and Sebastian Schmidt (2016). "The Risk-Adjusted Monetary Policy Rule," Finance and Economics Discussion Series 2016-061. Washington: Board of Governors of the Federal Reserve System, August.

1. I am grateful to John Roberts of the Federal Reserve Board for his assistance in preparing this text. These remarks represent my own views, which do not necessarily represent those of the Federal Reserve Board or the Federal Open Market Committee. Return to text

2. See Brainard (2018). Return to text

3. For example, the International Monetary Fund (2018) estimates that the tax cut legislation will raise the level of U.S. GDP 1-1/4 percent by 2020, and the Congressional Budget Office (2018, p. 13) estimates that increased spending caps will boost the level of real GDP by 0.6 percent in 2019. Return to text

4. The share of the labor force aged 25 or older with a college degree or more is around 40 percent today, compared with 15 percent in the late 1960s, and the share with less than a high school degree has fallen from around 40 percent to around 7 percent today. The unemployment rates of college-educated adults are typically much lower--around 2 percent today--compared with high school noncompleters--currently around 6 percent. Return to text

5. See Brainard (2017, 2018). Return to text

6. See, for example, Kiley and Roberts (2017), Nakata and Schmidt (2016), and Brainard (2015, 2016). Return to text

7. See Board of Governors (2018) and Brainard (2018). Return to text

8. An earlier paper discussing the predictive power of the yield curve is Estrella and Mishkin (1997). In more recent work, Bauer and Mertens (2018) emphasize that the predictive content of the yield curve is still largely intact. Johansson and Meldrum (2018) and Favara and others (2016), however, argue that adding information about bond risk premiums reduces somewhat the predictive power of the yield spread. Return to text

9. See Kim and Wright (2005) for technical details; the latest estimates are available on the Board's website at https://www.federalreserve.gov/pubs/feds/2005/200533/200533abs.html. Return to text

10. See, for example, Li and Wei (2013). Return to text

11. See Chen, Engstrom, and Grishchenko (2016). Return to text

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Fed Reserve Governor Lael Brainard: Growing above Trend, Sustaining Full Employment and Inflation around Target

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