The Federal Reserve will not only cut interest rates at this week's meeting but will also continue to cut rates in 2025.
According to a leading model calculated by the New York Federal Reserve, the current neutral interest rate is 0.8%. In contrast, the inflation-adjusted federal funds rate, using the Cleveland Fed's estimate of the one-year expected inflation rate, is 1.9%.
The actual federal funds rate may not be the best rate to compare against the neutral interest rate, but other short-term rates tell a similar story. For example, the current one-year Treasury real yield is 0.7% higher than the neutral interest rate.
Furthermore, over the past two decades, the real one-year interest rate in the U.S. 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. Thus, the current one-year real interest rate is nearly 3% higher than 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. In addition, expected inflation (used to calculate the current one-year real interest rate) cannot be directly observed and must be estimated. However, aside from these considerations, the current short-term real interest rates are clearly much higher than the average level.
Some researchers believe that the neutral interest rate may be lower than we think. Ricardo Caballero, an economics professor at MIT, is one such researcher. He recently proposed two main reasons why the neutral interest rate is likely to decline.
First is the 'unprecedented level of sovereign debt', which requires encouraging the private sector to be willing to lend money to the government. Although conventional wisdom suggests that this means interest rates must rise, Caballero argues that the opposite is true.
Caballero said, 'As the saying goes, “Small loans are a problem for borrowers; large loans are a problem for lenders.” In this case, the issue is total demand. The primary deficit of highly indebted countries is unlikely to sustain total demand indefinitely. Therefore, lower interest rates are needed to encourage the private sector to fill the demand gap.'
Caballero believes that the second reason for the decline in the neutral interest rate 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 risk of stocks, they 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 lower than the yield on the 10-year Treasury—3.9% and 4.4%, respectively. Given that the earnings yield of stocks is already far below the historical average, the increase in the risk premium is more likely to come from a decrease in interest rates.
Article forwarded from: Jinshi Data