U.S. Monetary Policy: 3-2-1, Interest Rate Liftoff!

IMF Blog, September 10, 2014

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After more than five years of exceptionally low interest rates, liftoff of U.S. policy interest rates from close to zero is expected to take place by around mid-2015.
Timing is not set in stone and will depend on the state of the U.S. economy; stronger data could move liftoff earlier, weaker data could delay it.
Based on the authors' most recent economic projections, there is some scope for policy rates to stay at zero for a little while longer than mid-2015, given remaining labor market slack and still low inflation.

Two main factors determine when the Fed will move policy onto the launchpad:
- How much “labor market slack” there is in the economy.
- The extent to which this slack translates into future wage and price inflation.

Unemployment rate:
- Stood at 6.1 percent in August.
- Short-term unemployment is 4.2 percent and below its long-run average.
Broader indicators of slack:
- Almost 3 million Americans have been jobless for at least 27 weeks.
- More than 7 million part-timers would like to work more.
- Close to 2 million others have stopped looking for work.
Adjustment horizon:
- At current rates of job growth, it may take 3 or 4 more years for the economy to fully absorb these workers.

Fed’s preferred measure of inflation (personal consumption expenditure inflation) was 1.6 percent in July.
This is still well below the Fed’s 2 percent target.
There is little sign of a concerted increase in wage costs, particularly relative to productivity.

Keeping policy rates at zero increases the likelihood that financial markets get ahead of themselves and investors over-reach.
Specific vulnerabilities:
- Lower-rated corporate debt accounts for a bit less than a quarter of the corporate bond market; valuations appear stretched and issuance has been brisk.
- Authorities are monitoring developments in the leveraged loan market and working to enhance supervisory guidance as underwriting standards deteriorate.
Asset management flows:
- Asset managers are increasingly investing in riskier and less liquid credit markets, raising the risk of a rush for the exits if expectations about Fed timing or pace change abruptly.
Macroeconomic cost:
- An abrupt reassessment of Fed liftoff timing or an unwinding of high risk tolerance could lead to a sudden re-pricing of assets with macroeconomic costs in the United States and abroad.

Use macroprudential policies as the first line of defense against financial excesses while monetary policy remains committed to price stability and maximum employment.
Examples of measures:
- More demanding underwriting standards for banks that extend intermediate leveraged loans.
- Tighter limits on large exposures to riskier assets.
- Tougher prudential rules for regulated entities that hold riskier assets.
- Actions to address the mismatch between liquidity promised to fund owners in good times and asset managers' ability to provide liquidity in stress.

Timing and communication are both critical for a successful liftoff.
The Fed’s communications toolkit should continue to evolve to update markets and the public on the outlook and policy stance.
Possible communication enhancements:
- More frequent press conferences.
- A regular monetary policy report that gives the Fed policymakers’ majority view on the outlook.
- Providing clarity about the role of financial stability in monetary policy decisions.

Timing the liftoff is a difficult judgement and will depend on how well the U.S. economy performs in the next several months.
While tangible risks to financial stability exist, the authors remain optimistic that a solid period of economic growth will facilitate a Fed interest rate lift-off.

Francesco Columba, Jarkko Turunen — September 10, 2014 — U.S. Monetary Policy: 3-2-1, Interest Rate Liftoff!