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Today's Bullets:
What is the Neutral Rate?
Why So Elusive?
Where We've Been
What Gives?
Inspirational Tweet:
As investors, analysts and economists all try to anticipate the Fed's actions—when exactly they will start lowering rates again—there's a term we've begun to hear being thrown around again:
The Neutral Rate.
Also known as R-Star, this important concept but near-impossible measure is critical for the Fed to formulate policy around.
The kind of concept that Powell will lose sleep over, in fact.
But if this has you scratching your head and wondering what all the fuss is about, have no fear. Because we're going unpack R-Star and it's importance right here today, nice and easy as always.
So, grab a cup of coffee and settle into your favorite spot, as we dig into some economist-speak with The Informationist.
🎯 What is the Neutral Rate?
The R* Neutral Rate.
You may recall me talking about it last year, but it bears another look today from a slightly different angle.
First, it's quite a popular term these days, as you can see how many times it has been mentioned in major news articles already this year:
The pattern of spikes usually occurs around the time that The Fed is changing the Fed Funds rate, either up or down.
Why?
Because the neutral rate is supposedly the short term interest rate that denotes a kind of perfect balance for monetary policy and the economy.
Economic equilibrium.
In the Fed's own words, the neutral rate is the short-term interest rate that would prevail when the economy is at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary.
That last part is the key.
It means the Fed is no longer interfering with the natural state of the economy. It has set rates at the perfect pitch for neither stimulation nor restriction.
Only one problem. Also in the Fed's words: the neutral rate cannot be observed directly; it can only be estimated.
And this estimation is about as elusive as a Himalayan snow leopard.
And so, while PhD economists sit around sipping organic-cucumber-infused gin and pontificating about the equilibrium rate, we can poke a little fun and ask them:
Is an R*star in the room with us now?
🔍 Why So Elusive?
In fairness, the neutral rate is difficult to calculate because it's nothing more than a theoretical concept that cannot be observed directly.
And so, its estimation relies on complex economic models that include a wide range of dynamic factors, such as productivity growth, inflation expectations, demographic changes, global financial conditions, etc.
And this means a whole lot of assumptions.
We all know the saying about assumptions. And on Wall Street, if an analyst resorts to using excess assumptions when creating a financial model, we call it garbage in, garbage out.
Maybe that's why the Fed is always overstaying its welcome and missing its timing on rate cuts.
But again, understanding what the Fed is thinking can be super helpful in anticipating their monetary moves and managing your investments around them.
As for what the Fed uses to estimate the neutral rate, there are two main models:
The Laubach-Williams Estimates and the Holston-Laubach-Williams Estimates.
Built by Federal Reserve economists Thomas Laubach, John Williams and Kathryn Holston, both techniques use sophisticated mathematical methods and algorithms that analyze macroeconomic data (GDP, inflation, etc.) over time to infer the rate consistent with full employment and stable inflation.
The Holston model simply extends the approach to refine the estimation.
Something important to remember when looking at charts or estimates from these models, they are quoted in real rates, meaning the estimated inflation rate has been subtracted from the rate.
Here's a chart of what the estimated neutral rate has been, according to the latest models:
As you can see, the model is estimating the current neutral rate (minus inflation) to be .88%. And, using the Fed preferred inflation measure of PCE (+2.9%) this means that Fed Funds would have to be ~3.77% in order for the rate to be neutral.
.88% estimated real neutral rate + 2.9% inflation = 3.77% nominal neutral rate
On the face of it then, with Fed Funds currently sitting at 5.5% on the upper bound, it would appear that the current Fed policy is restrictive.
Even the Fed itself has long said that it believes the long-term nominal neutral rate to be ~2.5%, over a full percent lower than the model shows today. Whether that is still true, we will get to in a minute.
In any case, this is why we have heard so many comments about and even pleas from pundits and politicians for a March rate cut.
On that...
✍️ Where We've Been
See, the market and investors and especially borrowers have become quite accustomed to an accommodative Fed.
What do I mean by that?
I mean that the Fed has been allowing real rates to sit far below neutral for a long, long, long...
Long. Time.
Check it out.
If we believe that the model is kinda, sorta close to the elusive measure of neutral rates, then Fed Funds has been holding rates too low for many years.
As you can see, Fed Funds minus inflation (blue line) has been lower than the HLM Neutral Rate Model (white line) since just before the Great Financial Crisis.
According to the model, then, the Fed has been accommodative for 15 years.
Did they not trust their own models?
Of course not, they knew exactly what they were doing, allowing the economy to run a bit hot for a while in order to manage the massive QE/QT program they had instituted in the GFC. They needed to sell those USTs they bought and put on their own balance sheet.
But as they were trying to do that, in September of 2019, the repo market locked up and shortly thereafter, we all went into lockdown.
Bye bye, dreams of restriction.
Rates collapsed.
Nominal and real.
M2 soared, inflation raged. And the Fed struggled to keep up, raising rates at a breakneck speed in 2022 and 2023.
But here we are, in restrictive territory once again, according to the models and inflation estimates.
So what gives? Why aren't they lowering to be accommodative yet?
🧠 What Gives?
If you've been reading some of the comments on the other side of the argument from imminent rate cuts, you may have also noticed that some investors and even Fed economists believe that the neutral rate may now be higher than the long-assumed 2.5%.
Creating headlines like this:
And why are they so reluctant to lower rates, insisting that the neutral rate may have crept higher in the last few years?
I would point to this:
When the Fed lowered rates in the early 70s inflation resurged, casing a lot of economic hardship. I remember, as I was a kid living through it.
And so, we have heard over and again that Powell wants to avoid a similar resurgence of inflation. In fact, he re-iterated this just last week at the Fed Presser:
"We know that reducing policy restraint too soon or too much could result in a reversal of the progress we have seen on inflation and ultimately require even tighter policy to get inflation back to 2 percent."
And there you have it.
Because economic indicators have not been broad enough (geographically and across sectors) bad enough (unemployment rising, housing and goods prices deflating) for long enough (a number of months straight), The Fed seems intent on staying pat.
What does this mean?
Well, if they wait too long (as they always do) then we will begin to see just how far above the neutral rate we've been.
And if it has, in fact, shifted higher at all.
That’s it. I hope you feel a little bit smarter knowing about neutral rates, what they mean, and how the Fed uses them.
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Talk soon,
James✌️