Why the Fed funds rate may not increase the long-term average for a few years

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The Fed funds rate

The Fed funds rate has remained near zero in the aftermath of the great recession. Since the interest rates were low, Treasury bond (TLT) yields remained low. With improvement in the economic fundamentals in the last few quarters, the credit spread of investment-grade (LQD) and high-yield (HYG) bonds over Treasury bonds has narrowed and stands at an all time low. The improvement in economic fundamentals has also propelled stock market indices such as the S&P 500 (VOO) and the Dow Jones Industrial Average (DJI) higher over the last year.

DJIA and S&P500- last one year 2014-05-26

While the economic fundamentals are improving, Dr. Dudley expects the Fed funds rate to remain lower than its long-term average for next few years due to three factors:

  1. Economic headwinds from the great recession may persist for next several years
  2. Slow growth in the labor force due to an aging population
  3. Changes in bank regulations
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While the household wealth has increased since the huge loss in the great recession, households and businesses are more cautious while investing to avoid a repeat of what happened in 2008. The Fed will have to continue to maintain lower-than-historical average rates for a few years until households and businesses start investing at a faster pace.

The aging population has led to slower growth in the labor force. However, the productivity growth remains moderate. The Fed will have to keep the rates low to drive gross domestic product (or GDP) growth by encouraging investments and consumption.

Stricter bank regulations have made the banks to maintain higher capital. As a result, the banks’ cost of capital is expected to increase substantially. Since the banks might not be willing to forgo business by increasing long-term interest rates, the Fed funds rate has to stay low to ensure sufficient bank profitability.

Dr. Dudley said that the Fed funds rate may remain well below the historical average of 4.5% for several years at 2% Personal Consumption Expenditures (or PCE) inflation. He added, “Precisely how much lower is difficult to say at this point in time.”

To learn about Dr. Dudley’s views on how the Fed will likely manage its balance sheet, continue reading the next section of this series.

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