Former Vice Chairman of the Federal Reserve: Neutral interest rates will rise moderately, and the US bond yield curve will continue to steepen

As the Federal Reserve's interest rate cut lands, the market's focus has shifted to "where will interest rates go," and where will the real R* (neutral interest rate) land?

Currently, the general market consensus is that the neutral interest rate may be higher than pre-pandemic levels, but there is no consensus on how much higher it will be. The level at which interest rates ultimately stabilize is crucial for the U.S. economy.

On Monday, former Federal Reserve Vice Chairman and Pimco Global Economic Advisor Richard Clarida pointed out in an article in the Financial Times that the neutral policy rate may rise slightly from the pre-pandemic 0.5%, but this increase will be moderate. Others believe that the actual neutral rate may need to be significantly higher than the Fed's current forecast of around 1%.

At the same time, Clarida noted in the article that it is more important to note that the U.S. bond yield curve will steepen, with term premiums currently positive and likely to continue to rise.

Neutral interest rates will be higher than pre-pandemic levels

The so-called R* refers to the interest rate range that can achieve "Goldilocks" for the economy, that is, neither too hot nor too cold, just right to maintain price stability and maximum employment, which is crucial for understanding the evolution of monetary policy in the coming years.

Richard reviewed the levels of neutral interest rates before 2008 and in 2018:

Looking back at 2018, inflation had reached the 2% target, and the economy was operating at full employment. That year, the Fed raised the federal funds policy rate to 2.5%, with the real rate at 0.5%, which many considered the "neutral" level of monetary policy.

In contrast, before the global financial crisis, the average real policy rate was around 2%, with the nominal fund rate close to 4%. Fast forward to today, the Fed's dot plot indicates that once inflation stabilizes at 2% and the labor market is fully employed, the target fund rate is around 3%.

Richard believes that the neutral interest rate will be higher than pre-pandemic levels, but the increase may be moderate, while other analyses expect the neutral rate to be higher:

Others believe that the actual neutral rate may need to be significantly higher than the Fed's current forecast of around 1%, as well as the current levels reflected in the financial markets. They believe that factors that have been suppressing rates before the pandemic are reversing, and the worrying U.S. fiscal outlook with rising deficits and debt. The U.S. may also be on the cusp of an AI-driven productivity boom, which could increase the demand for loans by U.S. companies.

Focus on the steepening yield curve, term premiums will continue to rise

However, Richard believes that it is more important to focus on the trend of the U.S. bond yield curve:

The inversion of the U.S. bond yield curve is not a new normal, but rare. Relative to the "front-end" rates set by the Fed, the U.S. yield curve will adjust by steepening in the coming years to balance the influx of significant demand and supply for U.S. fixed income.

Given the massive and growing supply that the bond market must absorb in the coming years, yields may be higher than in the pre-pandemic years. However, most adjustments will occur through the slope of the yield curve, rather than a significant increase in the federal funds rate itself. Richard further pointed out that term premium will continue to increase:

The current term premium is positive and may continue to increase. This is because bond investors need to absorb the bonds flooding into the market, requiring a higher term premium.