Seven years ago — to the day — the Federal Reserve made history: It moved its benchmark interest rate as low as it could — nearly to zero. By that point, the housing bubble had burst, major financial institutions had failed (or were bailed out), and the U.S. economy was rapidly contracting. The Great Recession was underway.
Since then, a lot has changed. The unemployment rate has fallen to 5 percent after peaking at 10 percent in 2009, GDP growth steadily recovered, and the S&P 500 has about doubled in value. Now the Fed is expected to raise rates after its policy meeting today. This era of near-zero interest rates is about to end.
As rates do begin to inch up, conversations about monetary policy will shift from what’s felt like a single-minded focus on when the Fed’s rate hike would come to a broader set of questions about what happens now. Here are four such questions:
Will inflation ever get back to normal?
Those arguing against a Fed rate increase — often labeled “doves” in monetary policy jargon — point to low inflation to bolster their case, saying that it’s a worrying sign of economic weakness.
And the doves have a point: Inflation has been unusually low for years. Take the Fed’s preferred measure of inflation, the personal consumption expenditures price index. PCE inflation is currently one-quarter of a percent year-over-year. This is far short of the Fed’s 2 percent annual inflation target. These exceedingly low inflation readings are partly caused by the dramatic fall in energy prices this year. But if one strips out volatile food and energy prices, as reflected in the “core” PCE measure, inflation is still up just 1.3 percent from a year ago. By any measure, prices aren’t increasing by much.
The problem here is not just that inflation is so low, but that the Fed keeps expecting it to move toward its target. As Josh Zumbrun outlined in The Wall Street Journal earlier this week, the Fed has forecast year in and year out that inflation will rise. But it hasn’t budged.
However, this hasn’t stopped the Fed from stating that it will raise rates when it’s “reasonably confident” that inflation will eventually rise to the Fed’s target. But doves believe that raising rates will prevent inflation from approaching the Fed’s target, trapping the economy in a cycle of mediocre growth.
The outlook for inflation will be the principal factor in how fast the Fed raises rates going forward. But also factoring into this debate is how fast the economy can reasonably be expected to grow.
How fast can the economy grow?
Is this the best the economy can do? For years, the rate of real GDP growth has barely budged above 2 percent. While this is a marked improvement from the depths of the crisis, it’s historically low.
As I wrote last year, the defining challenge for Federal Reserve Board Chair Janet Yellen is calibrating the Fed’s moves at a time when the economy’s maximum sustainable growth rate is declining. The Congressional Budget Office has concluded that the U.S. economy just can’t grow as fast as it once could. That’s partly because of demographics — an aging population slows potential growth — but the Great Recession is also to blame.
Take a look at the data. Potential GDP growth was around 2 percent when the Fed last changed rates, in December 2008. Fast-forward to 2015 and potential growth is a notch lower, at 1.75 percent. If the economy continues to grow, that rate will move higher, eventually plateauing around 2.25 percent in 2020, before beginning to decline again, this time slowly, as the effects of demographic changes kick in.
But growth in the “real economy” is not all that concerns the Fed, because financial developments can have profound effects, too.
Is another bubble imminent?
While the era of rock-bottom interest rates may have helped spur the recovery, many economists worry that it might have set the stage for another financial bubble. Because the Fed has made borrowing so cheap and easy, it risks encouraging companies and households to binge on debt, and the economy could suffer a crash as a result. The question then is in which part of the economy a bubble might be brewing.
As I wrote last year, the Fed has at times cast a worried eye on bond market activity. That’s the catch-all term for the multitrillion-dollar market on everything from corporate debt to mortgage-backed securities. As expected, ultra-low rates have led to a noticeable rise in debt across several sectors.
Another, more familiar, source of financial bubbles is the stock market. By any measure, stocks have recovered astoundingly well since the recession. The S&P 500 index is more than double its level in December 2008. But as the stock markets have set new highs, some worry that it has recovered too well and that stocks may be overvalued. One measure of whether stocks are overvalued is the price-to-earnings ratio; this measures how stocks are priced relative to the earnings of the underlying companies. The current ratio is about 25. That’s far below the dizzying peak during the dot-com bubble, but historically high nonetheless.
And there’s the housing market. Home prices have recovered nicely but remain far below the pre-crash levels. While there’s not much evidence for a nationwide housing bubble, specific metro areas are seeing astounding price increases.
It’s still up for debate whether one or more sectors of the U.S. economy show indications of a speculative bubble. But whether or not there will be another bubble, there will be another recession, and that will bring challenges for the Fed, too.
Will interest rates return to zero?
The economy is on much sounder footing now. But at some point, it will falter. One worry for the Fed is what to do with interest rates when the next recession strikes. The Fed often responds to recessions by lowering interest rates — but what if rates are too low to cut?
The pace of interest rate increases matters a lot here. The Fed has been extremely clear that it’s intent on raising rates very gradually. The chart below shows the projected path of the federal funds rate plotted alongside previous trajectories. Two years from now, at the end of 2017, investors expect the benchmark interest rate to still be less than 2 percent.
As I wrote in September, it’s likely that interest rates will be less than 2 percent by the time the next recession strikes; they will almost certainly be less than 3 percent. Usually the Fed cuts rates by 4 percentage points or more to combat a downturn. So the math is clear: There’s a very good chance that the Fed will be faced with near-zero rates again in the future. A Wall Street Journal poll of 65 economists found that a majority agreed that the Fed will be back at the zero lower bound again within five years.
Amid an improving economy, the Fed is set to mark the end of an era. But these questions, and many others, are still unanswered.
Disclosure: Andrew Flowers used to work for the Federal Reserve Bank of Atlanta, which is part of the Federal Reserve system.