Former Vice Chairman of the Federal Reserve: Neutral interest rates may not be raised significantly

Former Federal Reserve Vice Chairman and Pimco Global Economic Advisor Clarida analyzed the interest rate trajectory of the Federal Reserve in an article in the Financial Times.

After the Federal Reserve's first rate cut, the market discussion has shifted from "when" to cut interest rates to the "trajectory" of interest rates.

This shift is not just a matter of semantics. The final level of interest rates is crucial for the entire economy. However, discussions often focus too narrowly on the neutral actual Federal Reserve policy rate, known as R-star. This refers to the rate that neither stimulates nor restrains economic growth.

The neutral rate implies a range of interest rates that can achieve "Goldilocks" conditions for the economy, maintaining price stability and maximizing employment. While the neutral rate is crucial for understanding how monetary policy will evolve in the coming years, estimating it is not precise. It cannot be observed, changes over time, and is driven by domestic and global forces in the United States.

Looking back at 2018, when the inflation rate reached the 2% target and the economy was booming at full employment. That year, the Federal Reserve raised the federal funds policy rate to 2.5%, translating to a real rate of 0.5%, which many saw as the "new" neutral level of monetary policy.

In contrast, before the global financial crisis, the neutral rate averaged around 2%, with the federal funds rate hovering around 4%. Fast forward to today, the Federal Reserve's dot plot (policymakers' rate forecasts) indicates that once inflation stabilizes at 2% and the labor market is at full employment, the target federal funds rate will be around 3%.

I agree with the view that the neutral rate may rise from 0.5% before the pandemic, but I believe this increase will be moderate. Others believe that the neutral rate may need to be much higher than the Fed's forecast and the market's pricing of around 1% (i.e., 3% minus 2%).

They point out that factors that kept rates low before the pandemic have reversed, with concerns about the U.S. fiscal outlook, rising deficits, and debt. The U.S. may also be on the cusp of an artificial intelligence-driven productivity boom, which could increase demand for loans to U.S. businesses.

So, where is the real neutral rate? Of course, the U.S. Treasury and private sector borrowers issue bonds along a complete yield curve. Historically, the slope of this yield curve has been positive—interest rates rise over time to compensate investors for the risk of holding debt for longer periods. This is known as the term premium.

The rare occurrence of an inverted U.S. bond yield curve since the Fed's aggressive rate hikes is not a new normal. As the Fed's rate cuts lower the "front end" rates, the yield curve will adjust in the coming years, steepening relative to pre-pandemic levels to balance the demand and supply for U.S. fixed-income products. This is because bond investors will require higher term premiums to absorb the surge in bond issuance.

Like the neutral rate itself, the term premium is unobservable and must be inferred from noisy macro and market data. There are two methods to do this The first method is to estimate the expected average federal funds rate for the next 10 years through surveys of market participants and compare this estimate with the actual yield of 10-year US Treasury bonds. According to recent surveys, the implied term premium estimate using this method is 0.85 percentage points.

The second method involves using a statistical model of the yield curve, which yields a current term premium estimate of approximately zero. Personally, I prefer to rely on the method of surveys of market participants and believe that the current term premium is positive and may continue to rise.

Given that the market will need to absorb a large and growing supply of bonds in the coming years, interest rates may be higher than in the years before the pandemic. However, I believe that most of the necessary adjustments will be reflected in a steepening yield curve rather than a significant increase in the federal funds rate itself.

If my view is correct, this is a positive sign for fixed income investors. They will be rewarded for bearing interest rate risk during economic prosperity, and they will also benefit from the hedging value of bonds in their portfolios during economic weakness. At that time, there will be greater room for interest rates to fall, leading to an increase in bond prices