Neutral interest rate remains a mystery, will the Federal Reserve poke another big hole?

The so-called neutral interest rate, known as "r-star" by economists, is the standard for determining whether the Federal Reserve's interest rate policy is "tightening" or "loosening".

However, economists and market strategists have once again turned their attention to this long-standing and complex issue. As the neutral interest rate is a theoretical concept, no one can pinpoint its exact level.

Since the onset of the COVID-19 pandemic, senior Federal Reserve officials have held a broader view on what they believe the neutral interest rate to be. With the Fed seemingly prepared to continue cutting rates, this lingering uncertainty has started to make some on Wall Street nervous.

Their biggest concern is that the neutral interest rate may be higher than the Fed's expectations. If this turns out to be true, the Fed may inadvertently cut rates too aggressively, potentially triggering another wave of inflation.

In fact, some market-based indicators, such as the spread between the 5-year U.S. Treasury yield and the yield on the same-term inflation-protected bond, seem to be digesting these anxieties.

Since the Fed's first rate cut last month, this spread—more commonly known as the 5-year breakeven inflation rate—has rebounded. This suggests that some investors anticipate future inflation to be more stubborn.

5-year breakeven inflation rate

Is the Fed Overcutting Rates?

For now, most investors believe that these risks are largely secondary. While U.S. Treasury yields have risen since the Fed's significant rate cut in September, the stock market is primarily focused on signs that American consumers, the labor market, and the economy are showing resilience far beyond expectations.

It should be noted that the New York Fed defines the neutral interest rate as the rate that maintains full economic speed while stabilizing inflation. Data on actual GDP, inflation, and the level of the federal funds rate are used in the calculations of the New York Fed's main model.

An updated version of this model has been released, aiming to account for supply constraints caused by the COVID-19 pandemic. Like its previous version, it still indicates a significant decline in the neutral interest rate over the past few decades.

Vishal Khanduja, Portfolio Manager and Head of Macro Fixed Income at Morgan Stanley, stated that these factors and others imply that the real concern for investors should be if the Fed overcuts rates below the level of the neutral interest rate.

If this scenario materializes, the bond market may be the first to feel the impact. However, if volatility leads to sustained inflation increases, it could quickly spread to the stock market, currency market, and beyond.

Khanduja noted that the ongoing massive budget deficits of the U.S. federal government have made the already challenging task of modeling the neutral interest rate even more complex.

“This not only makes the Fed's job difficult, but also requires us as active fund managers to remain vigilant,” he told MarketWatch in an interview last week

Uncertainty Surrounds Neutral Interest Rates

Khanduja pointed out that the volatility of the latest economic data has made the process of predicting neutral interest rates more challenging. Since the Federal Reserve began raising its interest rate targets in the spring of 2022, the U.S. economy seems to have surprised economists at every turn.

The latest data from the labor market shows a decrease in the unemployment rate, an increase in job opportunities, and a slight rise in wage growth. Subsequently, some economists and investors have questioned whether the significant rate cuts by the Federal Reserve are an overreaction.

However, just two months ago, when an unexpectedly weak job report triggered a global stock market sell-off, a large group of critics warned that the Federal Reserve seemed to be behind the curve, with some even suggesting emergency rate cuts.

It wasn't until the release of the September Consumer Price Index (CPI) last week, which slightly exceeded expectations, that the situation became even more unclear.

With rising commodity prices and rate cuts by the Federal Reserve, some believe that this time the U.S. economy may be more susceptible to a sustained rebound in inflation, despite a previous transient inflation spike earlier this year.

Concerns about an overly strong economy have prompted warnings from Federal Reserve Governor Waller. He stated that the U.S. economy may not slow down as sharply as before, leading him to lean towards minor rate cuts in the future.

Market strategists have observed that the prospect of increased uncertainty due to the White House led by Vice President Harris, which may adopt a different fiscal policy from former President Trump, has added to the uncertainty.

George Brown, Senior U.S. Economist at Schroders, warned that the uncertainty surrounding neutral interest rates should convince the Federal Reserve to proceed cautiously, which could result in a slower pace of rate cuts than investors currently expect.

Brown said, "Neutral interest rates are an imprecise concept. It is not a measurable number but a theoretical rate considered to be neither too tight nor too loose to keep economic growth and inflation on a stable and predictable path.

"However, if an aggressive rate-cutting cycle becomes a reality, and the U.S. economy proves to be more resilient than Federal Reserve policymakers anticipated, U.S. rates could ultimately become too loose," he added, "they could potentially push rates below the neutral level and reignite inflation."

While Brown acknowledges that the Federal Reserve's forecasts for the level of neutral interest rates have steadily increased this year, he also emphasizes that current estimates by policymakers are much more diverse than pre-pandemic estimates, highlighting internal contradictions within the Federal Reserve.

According to the latest "dot plot" from the Federal Reserve, the highest estimate for the long-term policy rate is roughly in line with its perceived neutral rate, at 3.75%. The lowest estimate falls between 2.25% and 2.50%.

Federal Reserve Chairman Powell has previously acknowledged this uncertainty. Perhaps most memorably, in a speech he delivered in Jackson Hole, Wyoming in 2023, he stated that the Federal Reserve is trying to "navigate by the stars under a cloudy sky." The latest meeting minutes from the Federal Reserve provide more details on the intense debate among policymakers behind the scenes. In September, Federal Reserve Governor Bowman voted against the decision to lower the policy rate target by 50 basis points, becoming the first governor since 2005 to dissent on a major policy decision.

In addition, other Federal Reserve officials also expressed doubts about this decision.

Also last week, Atlanta Fed President Bostic told the Wall Street Journal that he is willing to keep rates unchanged at the remaining two policy meetings later this year.

According to CME Group data, interest rate futures traders believe that the likelihood of the Federal Reserve pausing rate hikes is slim, but they have significantly reduced their expectations for the Fed to cut rates to a 3.25% target by mid-2025