This Time is Different: Lessons from Past Tightening Cycles
Speaking today to the Forecasters Club of New York, Boston Fed President Eric Rosengren explained his views on the future trajectory of interest rate increases, citing a number of reasons to expect a more gradual normalization process compared to the last two tightening cycles (1994 and 2004). He called this more modest tightening path "both necessary and appropriate" given his analysis of the data.
In particular, Rosengren noted that inflation is lower and real GDP growth is slower than at the beginning of the previous two tightening episodes.
Concerning growth, Rosengren observed that over the past four quarters real GDP has averaged only 2.7 percent, in contrast to the two previous tightening cycles. Growth had averaged
3.4 percent at the beginning of the 1994 tightening cycle, and 4.2 percent in 2004.
Concerning inflation, Rosengren cited the persistent undershooting of Fed policymakers'
2 percent inflation objective. His own view of the forecasts for inflation, he explained, largely rests on whether he thinks the economy will continue to experience growth above potential and whether the subsequent declining labor market slack will be sufficient to raise his confidence that inflation will return to 2 percent in a reasonable time frame.
Turning to employment, Rosengren noted that although the typical, widely-reported measure of unemployment (known as "U-3") is lower now than at the outset of the earlier tightening cycles of 1994 and 2004, the broader definition of unemployment ("U-6", which includes those who are working part time for economic reasons and those only marginally attached to the workforce), is not particularly low compared to the start of the prior two tightening cycles.
"If one believes the broader measure of unemployment better captures slack in the economy, then labor markets would not be viewed as unusually tight for commencing the tightening cycle," he said. "This potential additional slack would also be a reason for policymakers to follow a more modest interest rate path at the beginning of a tightening cycle."
Rosengren also noted that Federal Reserve policymakers expect a gradual tightening cycle, as suggested by their published Summary of Economic Projections. The implied path is much slower than the path taken in 2004, with the federal funds rate increasing at roughly half the pace of that tightening episode.
Conditions this time "likely require a different path of tightening," said Rosengren. He also noted that "In my own view, given current and forecast conditions, not only is the pace likely to be gradual, but the federal funds rate in the longer run may be lower than in previous tightening cycles."
"The more gradual tightening cycle should enable monetary policymakers to gauge how tight labor markets can be while maintaining stable prices," Rosengren concluded. "The very low inflation rates here and abroad make it a particularly good time to not be too tied to imprecise measures of full employment."