My 5-year-old thinks I’m tall, even though I topped out at
5-foot-1 my freshman year of college. This just goes to show that everything is relative.

Take monetary policy, for example. Current Fed funds policy, which targets a range of 0.25–0.50%, seems on the extreme end of easy when compared to historic Fed funds
rates of 10% in the ’80s and 5% in the ’90s.1

Janet Yellen and the Board of Governors of the Federal Reserve have made clear it plans to follow December’s rate hike with further “removal of policy accommodation.” But just how much accommodation is there left to remove? Spoiler alert: not very much.

Monetary policy exists on a spectrum with accommodative policy on one end and restrictive policy on the other. Therefore, it stands to reason there is a theoretical place somewhere in the middle of this spectrum that is a “neutral” rate. A Fed funds rate below the neutral rate is accommodative – or easy – and supplies the economy with low interest rates and excess liquidity to spark growth and job gains. Conversely, a Fed funds rate above the neutral rate is restrictive – or tight – and acts as a coolant on economic activity.

For decades, policymakers and market watchers worked under the assumption that the neutral rate was a constant, and did not change over time. Yet as the economy has recovered from the Great Recession, a growing volume of research out of the Fed shows that the neutral Fed funds rate has fallen appreciably in its wake. In the graph below, we show an estimate from the San Francisco Fed.2 This has translated into a significantly lower neutral monetary policy rate.

Suddenly, the current stance of monetary policy doesn’t seem quite so easy. In fact, current policy rates look much closer to neutral. The past four tightening cycles (1986, 1994, 1999 and 2004) averaged 190 basis points of rate hikes per year.1 Compare that with the current implied pace of tightening of less than 25 bps per year.3 Even the Fed’s “dot plot” shows a pace of tightening of 75 bps per year,4 half the speed of past cycles.

Recently, regional Fed presidents have been trying to prepare the market for the second rate increase of this cycle, hinting that a rate hike at the September 21 meeting may be likely. This time, however, higher rates will seem low by historic standards. And tight monetary policy will still mean low nominal rates. Even Fed Chair Yellen has indicated that the lower neutral Fed funds rate will mean rate hikes are gradual, and that rates will remain low for some time to come.

Janet Yellen is 5-foot-3, by the way, so to me she seems tall. 


1 Federal Reserve Economic Data.
3 Bloomberg, June 20, 2016.
4 Summary of Economic Projections, June 15, 2016.

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