Source: Golden Ten Data

Federal Reserve Governor Waller said that the decline in neutral interest rates over time is likely due to major changes in global demand for safe assets, but he warned that unsustainable fiscal spending could change this trend.

Speaking at the Reykjavik Economic Conference in Iceland on Friday, Waller said, “America is on an unsustainable fiscal path. If the supply of US bonds starts growing faster than demand, it will mean lower US bond prices and higher yields, which will put upward pressure on neutral interest rates.”

The Federal Reserve governor did not comment on the outlook for recent monetary policy.

Federal Reserve officials have made long-term neutral interest rates (called r-stars by economists) a central topic of policy discussions this year.

Neutral interest rates are a theoretical concept that describes a policy setting that neither stimulates economic growth nor reduces demand. It cannot be observed in real time, and estimates of neutral interest rates are highly uncertain. The latest estimates of neutral interest rates announced by Federal Reserve officials in March ranged from 2.4% to 3.8%.

“One important fact about r-star is that it is a theoretical concept with no reliable and easy way to determine its value,” Waller said.

Despite this, policymakers are still wondering whether this interest rate has risen since the economy seems less responsive to higher interest rates than they had anticipated. They estimated the median inflation-adjusted interest rate of 0.6% in March. The current interest rate range is 5.25% to 5.5%, and the swap market prices inflation slightly above 2% for the next year, which means that the policy should be clearly restrictive, but the economy is still growing at a steady pace.

Waller focused his attention on 10-year US Treasury yields, using it as an agent for r-star, and listed several trends that could push it down:

Lower inflation and economic fluctuations make holding long-term US bonds more attractive;

The liberalization of global capital markets will help create more demand for safe liquid assets such as US bonds, thereby driving down US bond yields;

Increased dollar assets held by foreign official institutions (such as central banks and sovereign wealth funds);

Domestic demand for US bonds has increased because retirees need more safe and liquid assets, regulations require banks to hold more liquid securities, and the Federal Reserve itself has increased its holdings of US bonds.

Waller said, “I don't think any of these factors can explain R-Star's recent possible rise, but some of these factors may contribute to R-Star's rise in the future.”

editor/tolk