Is zero interest rate era coming to an end?

Greg Nash

The days of zero percent interest rates may be nearing an end, even as Federal Reserve Chairwoman Janet Yellen is holding back on mapping out her exact plan. 

The challenge facing Yellen and the Fed is identifying the right time for rate increases amid an undeniably improving, but still complicated, economic recovery.

Yellen opened her anticipated remarks Friday in Jackson Hole, Wyo., by noting the extensive progress the economy has made since the downturn, highlighting the fact that more jobs have been created than were lost in the recession, and the “surprisingly rapid” decline in the unemployment rate to 6.2 percent this year.

But at the same time, any enthusiasm was quickly tempered by Yellen, who noted that it took five years since the recession to reach this point, and even so, the labor market is still not fully recovered.

A central question for Yellen is exactly how much “slack” there is in the labor market. 

That is, how much of the nation’s potential labor force is not being captured by the unemployment rate? 

That would include people who have given up searching for work, and those working part time when they really want full-time jobs.

Yellen has indicated in the past that she believes there is still slack for the economy to absorb when it comes to jobs, but said Friday that tracking that accurately is “rarely simple.” 

Part of that challenge is figuring out how much of that slack is due to the cyclical economy, suggesting that some of those part-timers and frustrated seekers will eventually find their way back to the workforce. 

At the same time, Yellen and her peers need to figure out how much of the jobless issue is structural, as an aging population begins to leave the workforce permanently.

But amid all that conversation, few experts saw Yellen’s highly anticipated speech as marking any new trajectory.

“The speech is full of ifs, buts, coulds and mights, reflecting uncertainty over the degree of labor market slack, but overall the tone is balanced and suggests no dramatic change,” said Ian Shepherdson of Pantheon Macroeconomics.

A survey of economists conducted by CNBC showed that they believe the Fed is going to take a slow, deliberate approach when it finally does decide to raise rates. Those surveyed said they did not expect an initial rate hike until the middle of 2015, as the Fed has indicated.

In addition, the economists said they believed there would be a 30-month window between the first rate hike by the Fed and the last, with rates ultimately topping out at 3.16 percent. 

That duration of hikes would be longer than average over the last few decades, and would be even more extreme when considering that a high point of slightly above 3 percent would smash the current record for lowest final rate set by the Fed of 5.25 percent in 2006.

Philadelphia Federal Reserve President Charles Plosser said that monetary policy may not solve the lingering problems in the labor market. 

"I'm very uncomfortable with the notion that we have to keep monetary policy at zero interest rates until the labor market has healed completely,” he told Bloomberg Radio at the Fed meeting.

He also is pressing for the Fed to change its guidance, indicating that a rate increase will come sooner than planned. 

“The longer we wait, the bigger we risk we'll have to raise interest rates faster when the time comes" and quicker rate increases would be "more traumatic" for financial markets,” he said.

Economists like Mark Zandi of Moody’s Analytics don’t see the economy reaching full employment until 2016, where the majority of the slack issues Yellen discussed on Friday would be mostly cleared out of the labor market. 

“This includes absorbing the unemployed, those that have stepped out of the labor force discouraged by the lack of opportunity, and part-timers that want full-time jobs,” he said. 

Still, if the economy stays on that track then the Fed will need to begin raising interest rates next summer, leading to normalized short-term interest rates by late 2017. 

That would be consistent with a federal funds rate of just under 4 percent.

“The tension in Fed policy is whether they can normalize rates so long after the economy is at full employment and wage and price pressures are developing,” Zandi said. 

“Bond investors may revolt, pushing long-term rates too high and undermining growth. This is the most serious threat to optimism over the economy's outlook.”

Andrew Busch, editor of the political and financial newsletter The Busch Update, said the Fed is treading into unknown territory without a playbook and they’re being forced to guess their way through accommodative monetary policy. 

The Fed’s massive bond-buying program is set to end in October. 

The central bank will probably have to shift its interest rate policy to better coincide with the trajectory of economic growth, he said. 

Busch argued that if job creation and economic growth maintain their momentum over the next three months they will really have to “walk their policy forward” and move to raise rates by early 2015. 

“The fact is that the Fed needs to normalize interest rates at some point without detracting from the economy and historically they have waited too long and overreacted,” he said. 

“Whenever they start to raise rates it will be too late.”

Busch argued that one of the biggest labor market issues is a mismatch of skills, especially in the technology sector and that is a structural issue that the Fed can’t changed with its policy. 

Yellen said in her remarks that the Fed is trying to shake out where the cyclical and structural changes are in the labor market and how long they will persist. 

As long as she deems most of the problems as cyclical, the central bank isn’t likely to adjust their plan to raise rates next summer. 

Meanwhile, Federal Reserve of Atlanta President Dennis Lockhart said he is sticking with the central bank’s aim for a rate hike in mid-2015. 

“By that time, if all goes well, the economy will have made progress from where we are today and with a forecast of reasonably high confidence, will look like we're going to achieve our objectives and so I'm not one who is in a rush to really lift off soon,” he told Bloomberg. 

“I think the conclusions about the strength of the economy at this point have to be taken as tentative conclusions. I'd like to see a bit more evidence accumulate.”