Fed pledges to keep interest rates at zero for years

It's getting better, but not well. We know it's going to be good, but not when or how quickly we'll get to that point. We suspect it will take quite a while. Until then, we will keep the interest at 0%.

This roughly sums up how the Fed, the US central bank, views developments in the US economy. After the deep recession in the first half of the year, the US economy is recovering. Because the contraction has been so deep, the recovery in the second half of the year will also be considerable. But after that, it becomes more difficult for the economy to continue to grow rapidly. Uncertainty for the Fed is high, which is not surprising.

High uncertainty or not, the question facing investors, analysts and economists is: when can a change in the bank's policy be expected? "Until inflation hits a little over 2% for a period of time," the Fed's answer. The problem with that answer is that no one, including the Fed itself, has any idea how much is "something" and how long "a certain period" is exactly.

Take a different route
So we have to take a different route to answer that question, one that's a little more clearly marked. The law on the US central bank offers a solution. That law is clear in its description of what the bank must ensure, namely price stability and maximum employment. Price stability is when annual inflation is, on average, 2%. Maximum employment is reached when unemployment is around 4%. At the moment, inflation is significantly lower and unemployment well above those targets.

After the meeting on Wednesday, September 16, it has become clear that the Fed's Interest Rate Committee has little confidence in achieving those goals in the coming years. The bank sees annual inflation this year at 1,5% and eventually climbing to 2023% in 2. However, that is not enough for her to jack up interest rates, because the average for the period 2020 to 2023 is estimated to be lower than 2%.

Inflation without food and energy
In addition, it should be borne in mind that when the Fed talks about inflation, the bank understands it very differently than the ordinary American. The Fed is looking at something called core inflation, which is inflation without food and energy prices in it. The bank also looks at the core of an inflation measure, which is another measure reported in the news when journalists talk about inflation.

Without going into too much detail, the difference is that the Fed's preferred measure tends to be lower due to its different composition. This means that if the bank says it aims for more than 2% inflation, that means that the benchmark that the ordinary American has in mind should soon be about 2,5 to 3 percent.

Unemployment must go down
The bank expects unemployment to be around 2023% in 4. But.... the uncertainty about that expectation is enormous. Moreover, the chairman of the bank said that interest rates can only rise if unemployment falls to 4% and inflation rises too much. How much is 'too much', you ask? That depends on the drivers of the increase, from which level the increase comes and on the average depreciation of money in the previous years. In short: nobody knows, not even the Fed itself.

For those who find looking at unemployment and inflation too complicated or exhausting and think the focus on economic growth is enough, Fed Chair Jerome Powell said the following. "Basically, what we are saying is that interest rate policy will remain very loose well after the economy has fully recovered from the corona crisis." In other words: we need to see the economy recover, make up for the corona damage and grow further before we start thinking about rate hikes. They don't seem to be coming before 2023, if not longer. 

In fact, the Fed promised to keep interest rates at 0% for at least a few more years. The report shows that there is a good chance that it will take even longer before all the conditions for raising interest rates are met.

Edin Mujagic

Edin Mujagic is a macro-economist and chief economist at OHV Asset Management. He focuses on global central banks, and in his blogs he mainly writes about the ECB and Fed. He has also written several books.

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