LONDON, Feb 7 (Reuters) – If the drugs don’t work, the
dosage may be wrong.
With January’s blowout U.S. job gains defying gravity,
Federal Reserve officials are puzzling over just how much
pressure the brutal interest rate rises of the past two years
have actually exerted on the wider economy.
Some have started to opine again about whether the Fed’s
running estimate of the ‘neutral’ interest rate – the
theoretical rate that would keep the economy growing sustainably
over time without spurring inflation – has in fact risen since
the pandemic, unlike what most Fedsters still assumed as
recently as December.
And if that thinking on a higher neutral rate gains
traction, it could cut short the path of rate cuts ahead.
While it won’t necessarily mean even higher policy rates are
in store, the level of ‘restrictiveness’ the central bank is
placing on the economy may be judged to be less than thought,
imply fewer cuts ahead than markets are praying for if the
central bank needs to keep a rein on activity.
So far, so wonky.
A sometimes nebulous debate over the years, estimates of the
sustainable ‘real’ rate – or so-called ‘r*’ from the related
algebra – ebb and flow.
But it takes on importance for Fed watchers and investors
right now in the way this elusive rate may be used by officials
to assess just how ‘restrictive’ or ‘accommodative’ they think
actual policy rates are now in the wider economy.
And it’s not hard to see why they’re scratching their heads,
with U.S. economic growth purring above 3% last year at full
employment even after the 5-plus percentage points of interest
rate tightening since March 2022 – and with workers returning to
the labor force and productivity rates rising.
On Monday – three days after news that the U.S. economy
again trumped forecasters by adding more than a third of a
million new jobs last month – Minneapolis Federal Reserve
president Neel Kashkari restarted the debate.
“These data lead me to question how much downward pressure
monetary policy is currently placing,” he wrote.
“The current stance of monetary policy, which … includes
the current level and expected paths of the federal funds rate
and balance sheet, may not be as tight as we would have assumed
given the low neutral rate environment that existed before the
pandemic,” added Kashkari, who’s not a voting member of the Fed
policy committee this year.
“It is possible, at least during the post-pandemic recovery
period, that the policy stance that represents neutral has
increased.”
Kashkari went on to say that disinflation wasn’t necessarily
being caused by Fed policy, more healing supply-side problems.
And it was a question going forward how much the Fed needed to
stay restrictive if it wasn’t yet sapping growth.
LOSING THE PLOT
So where exactly is the rest of the Fed at on all this?
In December, the Fed’s 19 policymakers updated their
quarterly projections for policy rates and the economy –
electrifying markets at the time by pencilling in as much as 75
basis points of rate cuts for this year.
But the median of Fed forecasts for where they saw the
policy rate over the ‘longer run’ – seen as a proxy for
assumptions about the neutral rate – stayed at 2.5%. That makes
for an ‘r*’ of 0.5% when adjusting for inflation rate back at
target.
That longer-run Fed rate assumption has stayed at 2.5% since
the middle of 2019 despite all the dramatic upheavals around
COVID-19 and its aftermath – disruption which some private
investors suggest may have reshaped domestic economic dynamics,
global supply chains, international trade and energy
considerations for good.
And it has been cut steadily from as high as 3.8% when the
Fed ‘dot plot’ of projections was introduced in 2015.
Practically, a neutral rate of that level now means current
Fed policy rates in the 5.25-5.50% range are ‘restrictive’ to
the tune of about 238bps – leaving considerable room to cut
nominal rates while still bearing down on credit and economic
activity.
But if others on the Fed’s policymaking committee were to
lean to Kashkari and rethink their neutral rate higher at the
next meeting, it could reduce what the Fed sees as its scope for
cutting while still keeping a rein on a healthy economy.
Where might that go?
The median estimate is 2.5%, but outliers in December had at
least three Fed officials with neutral rate assumptions of
3.5-3.8% – or back to where Fed officials at large saw it 2015.
Hypothetically, if that were suddenly to became everyone’s
assumption in March, then it would reduce the view of current
restrictiveness to 150bps – and compare to the 100bps of rate
easing priced in over two years in U.S. Treasury yields.
Another gauge of where the Fed is at is what it sees as the
‘central tendency’ – stripping out the three highest and lowest
projections. That was 2.5-3.0% in December, although a touch
lower than the previous ‘dot plot’.
Whatever happens in March, this shift in thinking about the
economy’s extraordinary resilience toward higher interest rates
will now be watched closely. And it’s not just at the Fed, as
European Central Bankers suggested this week too.
And yet nudges higher or lower in the neutral rate may also
be as ephemeral as all other rates.
Just prior to last week’s Fed meeting, Bank of America’s
U.S. economists did a deep dive on neutral rate assumptions and
reckoned ‘r*’ had increased since the pandemic and currently sat
at about 40bps in real terms – roughly where the Fed sees it.
But it said the factors driving the higher neutral rate may
not be as durable as it now seems, with the seemingly resilient
jump in U.S. growth, greater labor force participation and
higher productivity facing headwinds again ahead.
“Demographics will likely reassert itself in coming years,
returning participation rates toward their longer run trend,
though how quickly this happens remains an open question.”
The opinions expressed here are those of the author, a columnist
for Reuters.
(Editing by Sonali Paul)
