The complications of liftoff: the Federal Reserve's struggle to normalize interest rates.

• Author: Berry, John M.

The Federal Reserve's target for overnight interest rates has been held close to zero for almost seven years. Now, with the nation's unemployment rate around 5 percent and the economy growing modestly, most of the central bank's Federal Open Market Committee had signaled by mid-November that they were ready to raise the federal funds rate target when they met in December. As most investors accepted that likelihood, the financial market's attention turned to what would happen next.

Several Fed officials, including Chair Janet L. Yellen and Vice Chairman Stanley Fischer, have said repeatedly that they expect the path of rates to rise very gradually. Several others on the FOMC, such as Esther L. George, president of the Kansas City Federal Reserve Bank, who wanted rates to go up long ago, clearly would prefer a much steeper trajectory. So the sharp disagreements within the committee over when the "lift off' should occur aren't going to go away just because it has happened.

In September, when FOMC participants last estimated where they thought the "appropriate pace of policy firming" would leave the fed funds rate target at the end of next year, the answers were all over the lot. One said the target should still be close to zero a year from now. Another said nearly 3 percent. Eight estimated between 1 and 1.5 percent, and the remaining seven fell between about 1.75 percent and 2.5 percent.

At the subsequent FOMC meeting in October, the Fed Board staff presented the results of extensive research directly related to that policy path. The research strongly indicated that it would take much lower interest rates than prior to the financial crisis to slow economic growth. And that in turn suggested the more aggressive rate trajectories could wreak havoc with the relatively modest amount of growth most of the policymakers expect over the next couple of years.

According to the FOMC minutes, the research showed that the level of the overnight interest rate-- adjusted for inflation--that is consistent with full employment and stable inflation is now is close to zero. This real rate, first described in the late nineteenth century, is known as the "natural rate."

The nominal fed funds rate is just above zero, and the inflation rate the Fed targets, the core personal consumption expenditure price index, is rising at an annual rate of a little less than 1.5 percent. That means that the real fed funds rate is roughly a negative 1.5 percent. With the natural rate around zero, that negative 1.5 percent difference is one measure of how much stimulus Fed policy is providing to the economy. It will diminish, of course, as the nominal rate target increases.

A key problem with this analysis is that the natural rate cannot be measured directly. It can only be estimated indirectly using econometric techniques. Nevertheless, there is broad agreement that it currently is around zero. At a Brookings Institution seminar just after the October FOMC meeting, John C. Williams, president of the San Francisco Federal Reserve Bank and formerly an economist at the Fed Board, and Thomas Laubach, director of the Board's Division of Monetary Affairs, released the latest results of research they have been doing on the natural rate since 2003. Their conclusion: After the start of the Great Recession, the estimated natural rate of interest fell sharply and shows no sign of recovering to its...