The Federal Reserve is being forced to reevaluate its most basic assumptions about the economy after trillions of dollars of stimulus and years of ultralow interest rates have failed to generate a more robust recovery.
For years, the central bank’s top officials pointed to “persistent headwinds” emanating from the Great Recession as the culprit for the tepid pace of the economy’s expansion: Government spending cuts were depressing growth. Households were paying off debt, spending less and saving more. Borrowing money got harder. Once those trends turned around, they argued, the economy would get back to normal.
Seven years after the recession officially ended, many of the headwinds have indeed dissipated — yet normal remains elusive. In its place is a gnawing fear that the economy has permanently downshifted into an era of weak growth that policymakers have little power to reverse. Fed officials have all but given up hope of the 3 percent rate of expansion once considered the baseline for a healthy economy. Instead, they are coming to grips with the possibility that lackluster growth is the best this recovery can offer.
The Fed’s most recent economic projections show growth leveling off this year at 2 percent and remaining there for the foreseeable future. That, in turn, has pushed down the central bank’s estimates of how high it will raise interest rates and how quickly it will do so. Speaking to reporters last month, Fed Chair Janet L. Yellen acknowledged that slow growth and low interest rates might be the United States' “new normal.”
“The Fed is coming to realize that the U.S. economy is a plane that is flying more slowly and closer to the ground, and it has to reset its expectations for what it can deliver,” said Vincent Reinhart, chief economist for Standish Mellon Asset Management and formerly a senior official at the central bank.
Headwinds from the crisis were one of the chief reasons the Fed kept its benchmark interest rate at zero long after the recession ended in 2009. In 2012, then-chairman Ben S. Bernanke cited lingering weakness in the housing market, difficulty in obtaining loans and government budget cuts as powerful but temporary factors holding back the recovery.
But a recent analysis by Goldman Sachs found each of those factors have now faded. Household debt as a percentage of disposable income has returned to its pre-crisis level. Home building has rebounded, and federal and state government spending is expected to provide a modest boost to the economy this year.
Abating headwinds suggest that the Fed should be contemplating raising its benchmark interest rate. And indeed, in a small but symbolic step, officials voted to increase it by a quarter percentage point in December for the first time in nearly a decade.
Since then, however, the Fed has been stuck. Instead of raising projections for economic growth, officials have lowered them. And instead of hiking rates this year, they repeatedly have delayed another hike. Officials are widely expected to remain on hold when they meet today in Washington, and many analysts believe the central bank will only increase rates once this year, if at all.
“The data over time has told them that the world is turning out perhaps a little different than they thought, and they’re gradually adjusting to that,” said Michael Gapen, chief U.S. economist at Barclays.
The Fed has long cautioned that there is no preordained timeline for raising rates. If the recovery were to pick up speed, the central bank can move more quickly. And amid questions about the strength of the economy, the Fed has stayed its hand.
But officials have not settled on an explanation for why both growth and interest rates are still so low, and the debate is likely to define how — and whether — the central bank ends its extraordinary intervention in the American economy.
Among the most prominent theories is one championed by former Treasury secretary and Harvard economist Lawrence H. Summers, which argues that deeper forces are discouraging business investment and miring the economy in an era of so-called "secular stagnation." As a result, interest rates are likely to remain unusually low.
Yellen initially rejected that assessment. In late 2014, she explicitly stated that “there’s no view” among officials that secular stagnation had taken hold. At the time, the central bank predicted interest rates would reach 3.75 percent in the long run, close to the historical average.
But over the past year and a half, Yellen has softened her stance. Officials now predict long-run rates — or what economists call the “neutral rate” -- will top out at just 3 percent.
“I think all of us are involved in a process of constantly re-evaluating where is that neutral rate going,” Yellen told reporters last month. “Maybe more of what’s causing this neutral rate to be low are factors that are not going to be rapidly disappearing but will be part of the new normal.”
Other Fed officials have publicly questioned the headwinds hypothesis. One of the consequences of the nation’s slow-growth economy is that the central bank has fallen short of its 2 percent target for inflation for years. Chicago Fed President Charles Evans recently suggested the Fed should consider not raising rates again until inflation is reliably hitting its target. Meanwhile, Fed Gov. Lael Brainard said low long-run rates are “likely to prove persistent.” St. Louis Fed President James Bullard has even stopped trying to predict what they might be.
“The best that we can do today is to forecast that the current regime will persist and set policy appropriately for this regime,” he said in a speech last month. “If there is a switch to a new regime in the future, then that will likely affect all variables — including the policy rate — but such a switch is not forecastable.”
Perpetually slow growth means that any turbulence has the potential to tip the economy into recession. Fears of weakness in China, Britain's vote to leave the European Union, plunging oil prices and a stronger U.S. dollar — each blow has spawned fears of a new downturn over the past year. Low inflation and even lower interest rates have also left the Fed with less ammunition to combat the next crisis and boost growth, trapping the economy in a vicious cycle.
The problem is not limited to the United States. Around the world, policymakers are grappling with what International Monetary Fund Managing Director Christine Lagarde has dubbed “the new mediocre” that is adding pressure to the recovery at home. Sluggish demand abroad has diminished the appetite for American exports and choked off another potential avenue for growth. The problem has been exacerbated by investors piling into U.S. currency and government bonds as a safe haven from turmoil around the world — all of which further curtails the Fed’s ability to raise rates.
There are other possible reasons for the United States' economic doldrums. Bernanke has suggested that the driving force behind low rates is a global glut of savings, first among emerging markets in Asia and now in Europe. Northwestern University economist Robert Gordon has faulted a slowdown in technological progress that has eroded growth and depressed interest rates. The country’s demographics are also shifting as baby boomers retire and fewer workers replace them, creating another impediment to a faster recovery.
Of course, the economy has gotten better over the past seven years, even if it hasn't taken off. Millions of workers lost their jobs during the recession and its immediate aftermath. Now, employers are hiring at a healthy clip, and the unemployment rate has dropped below 5 percent for the first time in nearly a decade. While the Fed may have been too optimistic about economic growth, the labor market has proven stronger than expected.
That has provided officials some hope that the recovery may yet find firmer ground. But with each passing year, the prospect dims a little more.
“In part they’re testing the idea whether monetary policy can alter or improve the long-run performance of the economy,” Gapen said. “It’s not obvious that it can. … But it’s an experiment worth running.”