In January, Paul Krugman estimated that short-term rates would remain low through the end of 2011. He based his estimate on historical precedent: The Federal Reserve typically doesn’t start raising rates until two and a half years after recessions end. (At the time, most people were expecting the current recession to run at least another six months.) Now Krugman has made a more careful estimate, based on economic principles rather than historical precedent. His new estimate: The Fed can wait at least another two years to start raising rates, and probably longer than that.
Krugman’s argument is based on two common economic rules of thumb, namely, the Taylor rule and Okun’s Law. His argument is simple, but I thought it would be helpful to explain his rules of thumb.
The Taylor Rule
The Federal Reserve has two distinct mandates, namely, to maintain price stability as well as full employment. The primary tool for achieving these mandates is the federal funds rate. When inflation gets too high, the Fed increases the Fed funds rate in order to slow the economy and dampen inflationary pressures. On the other hand, when unemployment gets too high, the Fed cuts the Fed funds rate in order to stimulate the economy and increase demand for labor. Adjustments to the Fed funds rate are decided by the Fed’s Board of Governors, but a Stanford Professor named John Taylor devised a simple rule that historically has done a good job of mimicking their decisions.
One version of the Taylor rule says that:
Fed Funds Rate = 2.1 + 1.3 x Inflation – 2.0 x Excess Unemployment
Excess unemployment is defined as the difference between the actual unemployment rate and the ‘natural’ rate, i.e., the rate that would prevail if the economy were operating at its potential. Take a look at the chart, below, which plots the Taylor rule formula along with the actual Fed funds rate.
The Taylor rule does a pretty good job of explaining the past behavior of the Federal Reserve. The largest deviation between the rule and the Fed funds rate occurred between 2004 and 2005, when the Fed held short-term rates well below the level suggested by the Taylor rule. (The Fed was criticized at the time – partly on the basis of the Taylor rule – for helping to inflate the housing bubble by keeping rates too low for too long.)The September unemployment rate was 9.8%. The natural unemployment rate is estimated to be about 4.8%, so excess unemployment is around 5%. Meanwhile, inflation has been running at around 1.6% (and appears to be trending down). If you plug those numbers into the Taylor rule, you get a Fed funds rate of -5.8%. Negative interest rates can’t exist in the real world (people would hold hard currency rather than lend it at negative interest), so the Fed has settled for the next best thing: 0% interest.
As long as the Taylor rule yields a negative result, the Fed will presumably want to keep the Fed funds rate at 0%. So when will the Taylor rule yield a positive result?
Krugman argues that inflation is unlikely to increase during the next couple of years. (Given the amount of idle capacity in the economy, it will be some time before competition for resources puts upward pressure on prices.) Assuming that he’s correct, unemployment must fall to around 7% in order for the Taylor rule to yield a positive result. How long will that take? That’s where Okun’s Law comes in.
Okun’s Law
Increases in population and improvements in technology drive long-term increases in economic output. Over shorter time periods, changes in output are also influenced by changes in the intensity with which resources are used. In particular, if there is a surge in the percentage of the population that is working, there will be a surge in output as well. Or to put it in more familiar terms, GDP generally rises faster than trend when the unemployment rate is falling. It turns out that this relationship can be readily quantified, in the form of Okun’s Law.
Take a look at the chart, below, which plots changes in unemployment against changes in GDP over the last 40 years.
Each data point represents a calendar year between 1969 and 2008. If you fit a line to the data, you get the following equation:Change in Unemployment = - 0.4 x ( Change in GDP – 3% )
As an example, if GDP rises by 4%, unemployment should fall by 0.4%. (Incidentally, the equation also says that if GDP rises by 3%, unemployment shouldn’t change. In other words, the equation implies that 3% is the trend rate of GDP growth.)
With the economy coming out of recession, GDP is likely to grow faster than trend for the next few years. How much faster? Krugman suggests that 5% is a safe upper bound for GDP growth. (I agree. Full-year GDP growth has exceeded 5% only once in the last 30 years. Most economists expect the current recovery to be slower than normal.) With 5% GDP growth, Okun’s Law says that the unemployment rate will fall by 0.8% per year. With unemployment currently at 9.8%, it will be another three and a half years before the recovery pushes unemployment down to the 7% threshold which would justify a positive Fed funds rate.
Note: Krugman’s two-year estimate was based on a more conservative set of assumptions. I assume that his conservatism was intentional. In any event, my goal is to help explain his reasoning, not to quibble with his numbers.
What does this mean for homeowners? Most floating rate loans are tied to LIBOR, which is driven by the Fed funds rate. Krugman’s argument suggests that borrowers with floating rate loans can breathe easy for at least another two years, and probably a good deal longer than that.
