Most economists believe that the neutral interest rate should be adjusted based on expected inflation rather than actual inflation. Currently, inflation in the USA has dropped significantly, however, the Fed's rate cut measures are raising expectations in the US bonds market for future inflation increases.

Renowned strategists believe that if the nominal neutral interest rate and the real neutral interest rate are much higher than the expectations of Fed officials, continued rate cuts by the Fed could possibly reignite inflation.

On Friday, October 25th, Yardeni Research President and Chief Investment Strategist, Edward Yardeni, published an article elaborating on the relationship between current inflation in the USA and the Fed's rate cuts. He indicated that fiscal policy will inevitably impact R-star, and the current actions of Fed officials seem to solely focus on monetary policy, hoping that R-star can solve the issues in fiscal policy. Overreliance on the neutral interest rate by Fed officials could lead to a reignition of inflation.

At a certain interest rate, an economy can maintain low inflation and a low unemployment rate - economists commonly refer to this ideal rate as R-star or R*.

The challenge lies in the fact that before the 50 basis point rate cut by the Fed in September, the US economy had already nearly achieved a state of low inflation and low unemployment, while the FOMC hinted at more easing policies in the quarterly economic forecast summary.

The summary indicates that FOMC members have a median forecast of 2.90% for the "long-term" neutral interest rate. They unanimously believe that this level aligns in the long term with a 4.2% unemployment rate and a 2.0% inflation rate.

This means that the actual neutral federal fund interest rate is 0.90% (actual neutral rate = nominal neutral rate - inflation rate), which is much lower than the current level.

Ahead of the September FOMC meeting, US economic data showed a relatively weak labor market, which raised concerns among Federal Reserve officials. However, after the meeting, September's job growth data exceeded expectations, and the wage data for July and August were also revised upwards, bringing the unemployment rate down to 4.1%. Meanwhile, the 'super core' inflation rate, excluding housing, remained well above 2.0% in September.

So why do some Federal Reserve officials still promise further rate cuts?

Yardeni stated that clearly, Federal Reserve officials believe that since the summer of 2022, inflation has significantly decreased, prompting the need to lower the nominal federal funds rate to prevent real interest rates from rising and limiting economic growth.

Federal Reserve officials hope to reduce the nominal federal funds rate towards their estimate of the real R-star. They are concerned that allowing real interest rates to rise could lead to inflation falling below 2% and potentially skyrocketing unemployment rates.

Yardeni believes that Federal Reserve officials are overly reliant on the R-star, yet even though the R-star does exist, the exact value of R-star cannot be known.

Following a substantial rate cut by the Federal Reserve on September 18th, the 10-year US Treasury bond yield surged, and the inflation premium also rose. This has sparked another debate about the post-adjustment R-star.

Yardeni mentioned that Federal Reserve officials intend to lower the federal funds rate due to a moderation in actual inflation. However, their aggressive rate cuts seem to be increasing market expectations for future inflation hikes.

However, most economists believe that theoretically, R-star should be adjusted based on expected inflation rather than actual inflation.

The next FOMC meeting will be held shortly after the US presidential election, with both presidential candidates leaning towards policies that may increase the federal deficit and lead to inflation consequences.

Yardeni stated that fiscal policy will inevitably impact the R-star, while Federal Reserve officials currently seem to only focus on monetary policy, hoping that R-star alone cannot solve the issues in fiscal policy - if the nominal and real R-star are much higher than expected by Federal Reserve officials, and if the Federal Reserve continues to cut interest rates, it could potentially reignite inflation.

Yardeni added: The signal given by the bond market is that relying solely on R-star may bring unexpected consequences.

Editor/rice