Source: Golden Ten Data
Author: Xiao Yanyan

“Federal Reserve microphone” Nick Timiraos recently wrote that in the debate over whether and when the Fed will cut interest rates, another important debate is unfolding: where will interest rates go in the long run? The crux of the problem is neutral interest rates: interest rates that balance supply and demand for savings while ensuring stable economic growth and inflation.

Over the past 40 years, particularly after the 2008 financial crisis, economists and Federal Reserve policymakers have continuously lowered their estimates of neutral interest rates. This view is ingrained in bond yields, mortgage interest rates, stock prices, and countless other assets. But now, some people see the reason for the rise in neutral interest rates, which could change a range of asset prices.

Neutral interest rates, sometimes called “r*” or “r-stars,” cannot be directly observed; they can only be inferred. Five years ago, after the Federal Reserve raised the benchmark federal funds rate to 2.4%, officials saw signs of weak economic growth and inflation, so they began cutting interest rates. This means that the neutral interest rate must be around this level, or even lower.

But when the Federal Reserve raised the federal funds rate to 5.3% last year, the highest level since 2001, the US economy seemed unaffected, which gave reason to think that the neutral interest rate might be higher. “The economy has withstood this test very well. Ten years ago, no one would have told me that we would raise interest rates to this level and have this kind of result,” said Joe Davis, chief global economist at Vanguard Group (Vanguard). “With the release of quarterly data, our belief in a higher neutral interest rate is growing.”

Is the neutral interest rate already higher, or is it still lagging behind?

Continued strong demand does not necessarily mean that neutral interest rates have risen; it may simply mean that higher interest rates have yet to play a role in the financial system. Households and businesses have locked in their low-interest loans and may be relatively immune to recent increases in interest rates.

But Kris Dawsey, head of economic research at hedge fund D.E. Shaw, said that based on the elasticity of economic activity to high interest rates, “one conclusion you can draw is that r-star must be higher. Another conclusion you can draw is that the economy is less sensitive to interest rates. I think based on the same set of information, this conclusion is completely true.”

Therefore, modelling the effects of interest rates requires not only estimating neutral interest rates, but also estimating the sensitivity of spending to changes in interest rates and the degree of lag between expenditure and price.

Jason Thomas, chief economist at private equity investment management firm Carlyle Group (Carlyle Group), said, “There are many things to be corrected, especially when mistakes in one area can easily be mistaken for misestimates in other fields.”

Every quarter, Federal Reserve officials forecast long-term interest rates, which is actually their estimate of neutral interest rates. Their median estimate fell from 4.25% in 2012 to 2.5% in 2019. After deducting the 2% inflation rate, the real neutral interest rate is 0.5%. The neutral interest rate climbed to 0.6% in March, but this still underestimates the extent to which these estimates have changed. In March of this year, 9 out of 18 officials kept the neutral interest rate above 0.5%. Two years ago, there were only two. Cleveland Federal Reserve Chairman Mester said that after predicting long-term US interest rates of 2.5% for many years, she raised her forecast to 3% last month.

Implications for the Federal Reserve

The controversy over r-star is likely to have little impact on the Federal Reserve in the short term, as current interest rates are almost higher than all estimates of neutral interest rates. This means that current interest rates are holding back economic growth and price increases, and that nominal interest rates are more likely to fall rather than rise in the future. If the US economy continues to be strong and inflation is stubborn, it may trigger market speculation that neutral interest rates will rise, leading to the belief that current interest rates are not that tight. Seen from this perspective, there is no reason for the Federal Reserve to cut interest rates.

Another situation is that if inflation returns to a downward trend, discussions on neutral interest rates will focus on the extent of the Federal Reserve's subsequent interest rate cuts. There is no doubt that the Federal Reserve wants “policy normalization,” but where is the “normalization”? Goldman Sachs chief US economist David Mericle said they won't stay at 5%, but they won't go all the way down to 2.5%. They (probably) felt it would be more comfortable to stop within the 3% or 4% range, but that's still undecided.

Reasons for the rise in neutral interest rates

People cited several factors to explain why neutral interest rates are likely to rise: soaring government deficits, strong investments driven by a green energy transition, and a fervor fueled by artificial intelligence for power-intensive data centers. Higher productivity brought about by artificial intelligence may also boost long-term growth rates and neutral interest rates.

Dallas Federal Reserve Chairman Logan warned in a recent speech that due to rising neutral interest rates, interest rates may not be as restrictive as people think. “Failure to recognize the continued rise in neutral interest rates may lead to excessive monetary policy easing,” she said.

Investors have concluded that interest rates are unlikely to return to the low levels that prevailed before the pandemic. Interest rate futures indicate that the federal funds rate will stabilize at around 4% in the next few years.

“We can only understand it by what it does”

Others are skeptical that neutral interest rates are rising. New York Federal Reserve Chairman Williams has said that he expects an aging global workforce to boost savings and keep neutral interest rates low. Williams participated in writing a widely adopted r-star model.

Federal Reserve Chairman Powell and some colleagues believe that a stronger economy can also be easily explained by the characteristics of the epidemic. For example, immigrants increased the labor supply last year. “That's not to say the policy isn't restrictive, or that it doesn't respond to interest rates. Instead, we were temporarily affected by external forces,” Powell said in a conversation this month.

Federal Reserve Governor Waller has stated that he thinks R-Star is around 0.5%. He said last month, “You have to explain to me why real interest rates on safe, highly liquid government bonds have been falling for 40 years and then suddenly rebounding. No one really gave a good answer.”

Some economic models attempt to estimate neutral interest rates, but they have a wide margin of error and are easy to correct. Given this imprecision, Powell implied that the Federal Reserve must act on the assumption that it doesn't really know where the r-star is. “We can only understand it by what it does,” he said last year.

Editor/Jeffy