After the last policy meeting of the year, Nick Timiraos, a prominent reporter known as the 'Fed's mouthpiece' from the Wall Street Journal, pointed out that the Fed is entering another significant debate: Has the era of ultra-low rates come to an end? The answer to this question is crucial. Some believe that if policymakers confirm that the neutral rate has risen, the Fed may be nearing its destination regarding rate cuts. The full content is as follows.
On Wednesday local time, Fed Chair Powell hinted that the Fed is ready to pause rate cuts, and the magnitude of the cuts could be less than previously thought, sending shivers through investors.
Powell described the recent rate cut as an effort to adjust borrowing costs to a more 'neutral' level, raising a meaningful question that has only recently begun to be addressed: where exactly is the neutral rate in the post-COVID economy?
The neutral rate, or the rate that maintains full employment and stable inflation, cannot be directly observed. Instead, economists and policymakers infer it from economic behavior. If borrowing and spending are strong and price pressures are rising, current rates are below the neutral level. If borrowing and spending are weak and inflation is receding, rates are above the neutral level.
Earlier this year, the debate over the neutral rate was not particularly significant, as nearly all Fed officials believed that rates were at a restrictive level. This was because officials had significantly raised rates in 2022 and 2023 to lower inflation by cooling economic activity.
But now the questions regarding the neutral rate have become paramount, as the Fed has lowered rates by a full 100 basis points, and the economy seems to be in fairly good shape. Just as a captain tries to avoid crashing the ship into the dock, if the Fed believes that they are closer to their final destination due to the rise in the neutral rate, they may become more cautious in their rate cuts.
Powell stated on Wednesday local time, 'We do not know where it (the neutral rate) actually is, but... we can be certain that we are now closer to it by 100 basis points. From here on, this is a new phase, and we will be cautious about further rate cuts.'
In September, Powell stated that rates are unlikely to return to the ultra-low levels seen before the pandemic, when many countries were issuing negative-yield bonds. 'My own sense is that we won't go back to that era, but honestly, we will figure it out,' he said. 'I think the neutral rate could be much higher than it was then.'
While officials are trying to figure out the neutral rate, Trump has promised to reform trade and immigration policies. New shocks could complicate efforts to determine the new normal for the economy. With inflation still above target, this could further increase caution around rate cuts.
Expectations for the neutral rate are gradually rising.
After the 2008 financial crisis, economists and Fed policymakers steadily lowered their estimates of the neutral rate. Ultra-low rates and significant monetary stimulus did not provide much economic boost. Some economists believe low rates will persist due to demographic headwinds from an aging workforce and a long-term shortage of new investment demand.
Some economists believe that during the pandemic, a series of fiscal stimulus measures pushed the economy into a new equilibrium, leading to an increase in the neutral rate over the past few years.
Over the past decade, the view that borrowing costs will remain low has been ingrained in bond yields, mortgage rates, stock prices, and countless other assets. For example, a higher neutral rate outlook suggests that mortgage rates may remain above levels seen in the 2010s.
Economists cited several factors that might push the neutral rate higher, including increased government deficits reducing private savings. Meanwhile, investment demand may be higher due to the outlook for the green energy transition, supply chain diversification, and the AI-driven frenzy for power-intensive data centers.
Over the past year, Fed officials' estimates of the neutral rate have also gradually increased.
Fed officials predict the stable level of interest rates over the long term each quarter, which is essentially their estimate of the neutral rate. Their median expectation has dropped from 4.25% in 2012 to 2.5% in 2019, remaining at that level into 2023. However, in all four quarters of this year, this prediction has steadily risen, reaching 3% in the forecasts released on Wednesday.
Eight out of 19 officials estimate it to be above 3%. In June 2023, only two officials believed the neutral rate was above 3%. Following the recent rate cut, the benchmark federal funds rate will remain around 4.3%.
Misjudging the neutral rate could lead to a sharp policy turnaround.
For a long time, Powell has been dismissive of making policy based on overly precise estimates of the neutral rate. The Jesuit-educated central bank leader often asserts that officials can only 'understand it through its effects.'
As a result, even if the neutral rate rises, 'we will not have clear, strong evidence' to timely formulate corresponding policies, stated Jon Faust, who served as Powell's senior advisor from 2018 to June.
He stated that there are ample reasons to believe that the neutral rate could be as low as 2.5% and as high as 4%.
Before this week's rate cut, some Fed officials had already begun to express unease, concerned that the Fed might cut rates further based on a potentially flawed expectation of the neutral rate.
Dallas Fed President Logan stated in a speech last month that 'the strategy of repeatedly lowering the federal funds target range to a more neutral level relies on confidence that the neutral rate is significantly below current levels.' Recent data has provided evidence that the neutral rate has risen, and 'there are some signs that it may be very close to the current level of the federal funds rate.'
Logan warned that if the Fed cuts rates beyond the neutral level and inflation re-accelerates, the Fed could face the unpleasant prospect of having to raise rates.
Is the economy entering a new normal?
It is certain that the strength of the economy in recent years in the face of higher rates may reflect some temporary factors, such as increased immigration or households and companies locking in lower rates during the pandemic. Some economists believe that as these forces diminish, the Fed's rate stance may begin to have a more severe impact on economic activity.
However, Jason Thomas, chief economist at Carlyle Group, stated that as time goes on and the economy grows steadily, 'this should at least raise policymakers' vigilance' that the neutral rate may be higher.
Ten years ago, market participants and the Federal Reserve slowly concluded that the lower neutral rate was not merely a result of the Fed's accommodative monetary policy but reflected broader structural forces. Similarly, today, investors and policymakers may only conclude in the coming years that a higher neutral rate may not solely reflect the Fed's rapid rate hikes in 2022-23 to curb high inflation.
Thomas said that recent data shows improvements in labor productivity, 'In my view, this is an economy that is completely different from what was observed in the decade following the global financial crisis.' By next spring, more economic participants may 'realize that “the increase in the neutral rate is all the Fed's fault” does not fully explain the current situation.'
He stated that if officials conclude that the neutral rate has risen, the Fed may stop cutting rates for quite some time.
Eric Rosengren, who served as Boston Fed President from 2007 to 2021, stated, 'The recent rate cut has brought rates down to a level low enough that policymakers might say, “This could be the upper limit of the actual neutral rate, and we’ll just wait and see.”'
Article reposted from: Jin Shi Data
