Evidence that the U.S. neutral rate of interest remains stalled near zero spurred the Federal Reserve to slow its expected pace of rate hikes on Wednesday, as policymakers signaled their hands may be tied until a rebound in global demand or other forces raise that key measure of the economy's underlying strength.
In a news conference following the Fed's latest meeting, Chair Janet Yellen said the central bank was still coming to grips with the likelihood that the neutral rate - the point at which monetary policy is neither spurring nor restraining economic growth - is stuck at a historic low and could limit the central banks room to maneuver.
In the Fed's policy debate, "an important influence is what will happen to that neutral rate," Yellen said, noting that the central bank's "base case" is that the rate should rise alongside an improving economy and as "headwinds" from the 2008-9 financial crisis fade.
But "there are long-lasting, more persistent factors that may be holding down the longer-run level of neutral rates," Yellen said.
"It could stay low for a prolonged time....All of us are in a process of constantly reevaluating where the neutral rate is going, and what you see is a downward shift over time, that more of what is causing this to be low are factors that will not be disappearing."
Policymakers nodded directly at the problem in fresh economic projections that cut median estimates of the long-run federal funds rate to 3 percent, far below the levels common in the 1990s. Since the Fed began publishing policymakers' economic projections in 2012, estimates of the long-run rate have been cut from 4.25 percent.
"There could be revisions in either direction," Yellen said. "A low neutral rate may be closer to the new normal."
Hard to Pinpoint
Though difficult to pinpoint, estimates of the neutral rate provide a key yardstick to gauge whether a given federal funds level is stimulating or restricting the economy.
With the Fed still trying to encourage spending, investment and hiring, a low neutral rate means the Fed has less room to move before that stimulus is gone.
Fed estimates published online show little consistent movement in the neutral rate in recent years even as the labor market tightened and growth continued above trend, confounding expectations that it would move higher in an economy expanding beyond potential.
Officials cite a variety of possible explanations, but the result is the same: until policymakers are satisfied that the neutral rate is moving higher, they face an effective cap of 2 percent or even less on the federal funds rate.
Coupled with a 2 percent inflation rate, the Fed's target, that would put the "real" federal funds rate at zero. If inflation remains below target, the ceiling on the Fed would be that much lower as well.
That is a far cry from the 3.5 to 4 percent that the Fed's policy rate has averaged since the 1990s, and means the central bank will treat each move with particular caution, current and former Fed officials say. In their policy projections on Wednesday, Fed officials slowed the pace of expected future hikes from four to three per year.
It also means the central bank would be stuck near zero, and more likely to have to return to unconventional policy in a downturn; it could also force discussion of whether to raise the inflation target in order to try to push the entire rate structure higher.
The Fed has been waylaid more than once in its rate hike plans by the state of the global economy, and held steady again on Wednesday in part because of Britain's upcoming vote on whether to leave the European Union.
But recent data and Fed discussion of the neutral rate show the more chronic influence that low global rates and weak global growth may exert on the Fed.
According to the economic model typically cited by Yellen and others in discussing the neutral rate, conditions are ripe for it to move higher and give the Fed the room it needs to raise rates.
That model, developed by San Francisco Federal Reserve Bank President John Williams and the board's Monetary Affairs director Thomas Laubach, estimates that the inflation-adjusted size of the U.S. economy moved beyond its potential nearly two years ago, and that the positive "output gap" has been growing larger.
In general a larger output gap would produce a higher estimate of the neutral rate. However, in the time since the economy moved beyond potential in 2014, the model's estimate of the neutral rate has remained below zero in all but the first quarter of this year.
Bonds Dip to Negative Yields
As the Fed contemplates when to move next, the dynamics working against it were obvious this week when the yield on Germany's 10-year bond dropped into negative territory, helping keep the spread between it and the U.S. 10-year Treasury note near a euro-era high.
That gap in risk-free yields, and the United State's general performance relative to Europe and Japan, has driven the dollar higher, curbed U.S. exports, and may have fed through to the recent hiring slowdown in the U.S. industrial sector - all factors that could help depress the neutral rate.
A move higher in U.S. target rates risks reinforcing those trends, likely leading the Fed to feel its way forward until Europe and Japan can also move from the zero lower bound - a day that may be far in the future.
"If anywhere along this path international conditions or skittishness become such that the dollar takes off and capital flows disrupt a weak world and all of that affects inflation and job gains, then we will have a real fundamental question for them to resolve," said Jon Faust, a Johns Hopkins University professor and former advisor to the Fed board.
"How hard do we push on going it alone?"