The Fed will not only cut rates at this week's meeting but will also continue to do so in 2025.
According to a leading model calculated by the New York Fed, the current neutral interest rate is 0.8%. In contrast, using the Cleveland Fed's estimate of the one-year expected inflation rate, the inflation-adjusted federal funds rate is 1.9%.
The actual federal funds rate may not be the best rate to compare with the neutral interest rate, but other short-term rates tell a similar story. For example, the current one-year real yield on U.S. Treasuries is 0.7% higher than the neutral interest rate.
Furthermore, over the past twenty years, the U.S. one-year real interest rate has mostly been below the neutral interest rate—actually averaging 1.4% lower since 2003. Even if we disregard the period of the COVID-19 pandemic from 2020 to 2022, which is generally considered an exception, the one-year real interest rate has averaged 1.2% lower than the neutral interest rate. Therefore, the current one-year real interest rate is almost 3% above the average level relative to the neutral interest rate.
It is important to note that this conclusion comes with many caveats. The neutral interest rate cannot be directly observed, and different models will provide different estimates. Additionally, expected inflation (used to calculate the current one-year real interest rate) cannot be directly observed and must be estimated. However, setting these aside, the current short-term real interest rate is clearly far above the average level.
Some researchers believe that the neutral interest rate may be lower than we think. One such researcher is Ricardo Caballero, an economics professor at MIT. He recently proposed two main reasons why the neutral interest rate is likely to decline.
The first is the 'unprecedented levels of sovereign debt,' which necessitates encouraging the private sector to be willing to lend money to the government. While traditional views hold that this means interest rates must rise, Caballero argues that the opposite is true.
Caballero said, 'The saying goes, “Small loans are a problem for borrowers; large loans are a problem for lenders.” In this case, the issue lies with aggregate demand. The main deficit of highly indebted countries is unlikely to sustain aggregate demand indefinitely. Therefore, lower interest rates are needed to encourage the private sector to fill the demand gap.'
Caballero believes that the second reason the neutral interest rate will decline is that he thinks the risk premium—the difference between expected returns on stocks and fixed income—will have to rise from its currently low level. To attract investors to take on the risks of stocks, equities must offer a higher expected return than U.S. Treasuries; however, the current earnings yield of the S&P 500 (the inverse of the price-to-earnings ratio) is below the yield on 10-year U.S. Treasuries—3.9% and 4.4%, respectively. Given that the earnings yield of stocks is already far below the historical average, the increase in risk premium is more likely to come from lower interest rates.
Article forwarded from: Jin Shi Data
