By Mike Dolan
LONDON (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.