Fed’s ultimate destination
The Fed chair said it’s time to adjust policy rates. But he didn’t say by how much, and that’s all that really matters now for bonds.
Before Powell even approached the podium, the market was expecting about 2.25 percentage points worth of easing to take the fed funds rate to around 3%-3.25%.
If longer-term borrowing costs are to continue declining, it will have to come from a reassessment of the Fed’s ultimate destination.
Longer-term rate expectations stem from a highly academic debate of the neutral rate of interest, or r-star
The neutral rate is that which neither fans nor restrains economic activity.
Up until recently, markets and policymakers largely thought that the long-run neutral rate was around 2.5% (or 0.5% “real,” adjusting for inflation at 2%).
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RE: En halv procents realränta? Orkar inte ekonomin med högre realränta än så?
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Yields on 10-year Treasury notes sit around 3.80%.
If you assume that the fed funds rate will be between 3% and 3.25% there really isn’t room for the yield on the 10-year note to move much lower.
That would take a meaningful reassessment of neutral.
Unfortunately, it’s impossible to estimate neutral in real-time with a high degree of confidence,
as Powell himself has noted in previous Jackson Hole lectures.
In 2018, he said that “the location of the stars have been changing significantly.”
In 2023, he used similar language: “As is often the case, we are navigating by the stars under cloudy skies.”
In practice, policymakers try to feel their way to neutral by moving slowly.
The New York Fed’s John Williams, one of the most famous academic r-star gazers, is skeptical that there’s indeed been a sizable move up in the long-run “neutral” rate, and I’m sympathetic to that view.
Many American households and businesses locked in ultra-low interest rates and amassed large cash hoards during the pandemic, which made them seem initially insensitive to the monetary policy medicine.
But it may not matter what the experts and pundits say at this point; the changing perceptions about neutral will be hard to undo. Policymakers will ultimately find their way to r-star ploddingly and empirically, meaning it could take years for the debate to be settled.
Even if the r-star doves are right, estimates of neutral may not fully return to 2.5% until 2027 or 2028. That means that the rally in Treasury notes may soon hit a wall.
Jonathan Levin Bloomberg 23 August 2024
RE: Det intressanta är inte när sänkningarna börjar, utan var de slutar.
Bill Dudley: I think r* is a lot higher than the Fed recognizes
With large fiscal deficits and strong investment demand for the green economy and advanced technology putting pressure on borrowing costs, the so-called neutral interest rate is likely to be higher than in the past, according to Summers.
“I think the Fed’s making a serious mistake by believing that the neutral interest rate is so low, and therefore is misjudging how restrictive any given level of policy is,” he said.
“And if you don’t have the right North Star, you don’t navigate very accurately.”
Bloomberg 23 August 2024
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