The trouble with pinning down the neutral rate

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Good Morning. A strike by US dock workers began on Monday. If an agreement is not reached in the coming weeks, a quarter of US trade could be disrupted, leading to potential inflation. How will the Federal Reserve and the market react to a new supply shock, just as the previous one seemed to be fading? Rob is away for the week, so you have me today. They say, when the cat’s away, the mice will… deliver timely market and economic insights. Reach out to me at aiden.reiter@ft.com.

The neutral rate

Throughout this interest rate cycle, there has been much discussion about the neutral rate, also known as r*, or the long-term interest rate that supports low inflation and full employment. The neutral rate is important for markets and investors as it influences the rate at which capital is accessible in the long run, and where investments will flow. If the Fed overshoots r* while lowering interest rates in the next few months, inflation may rise.

Unhedged recently noticed that the Fed has been increasing its consensus estimate for r*:

However, there is significant disagreement within the Fed regarding this number. Estimates of r* range from 2.3% to 3.75%, with very few estimates receiving multiple votes. This contrasts with more consistent estimates in previous summaries, indicating a lack of certainty regarding the long-term neutral rate. The Laubach-Williams estimate, based on GDP and market data, has also been declining over the same period, adding complexity to the situation:

This uncertainty is not surprising, as r* is challenging to measure and is often exceeded by the Fed rather than approached cautiously. This is because r* represents the relationship between investment and savings across an entire economy. If savings are too high across various sectors, r* must decrease to stimulate investment and growth, and vice versa. Numerous factors, from population size to productivity, consumer confidence, and more, influence r*, making it difficult to predict its precise value.

Most economists agree with the Fed that r* is likely to increase in the US in the long run. Some reasons supporting this view include:

• Recent experience: Despite high rates in recent years, the US economy has remained strong, indicating a shift in underlying investment and savings patterns that may have raised r*.
• New technologies: Ongoing investments in artificial intelligence and green technology may require higher rates to prevent overheating as these sectors grow.
• Deglobalisation: Changes in global economic dynamics, including reduced US-China tensions and shifts in trade patterns, could lead to higher neutral rates.

While the market appears to support these arguments, potential challenges exist in each scenario. For instance:

• Recent experience: The unusual circumstances of the current economic cycle may not accurately reflect long-term trends.
• New technologies: The impact of AI on productivity and investment remains uncertain, with potential outcomes affecting savings and investment rates.
• Deglobalisation: Despite changing global dynamics, the US economy continues to attract capital, and the direction of US-China relations remains uncertain.

In a recent blog post, economist Ricardo Caballero highlighted the potential impact of increasing sovereign debt on future interest rates, suggesting that governments may need to lower rates to stimulate domestic demand as deficits are reined in.

Demographic trends also play a role in determining r*, with aging populations potentially impacting inflation and savings rates. The US’s demographic outlook, influenced by factors like immigration and fertility rates, adds further complexity to predicting r*.

While r* may indeed rise as suggested by the Fed and the market, the lack of consensus among experts and the presence of counterarguments underscore the need for continued analysis and adaptability in monetary policy and investment decisions.

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