The problem of setting the neutral rate

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Good day. American dock workers began striking on Monday. If a deal is not reached in the coming weeks, a quarter of American trade could come to a standstill and inflation could begin to rear its ugly head again. How will the Fed and the market respond to a new supply shock, just as the previous one seemed to be in the rearview mirror? Rob will be out for the rest of the week, so you’re in my hands today. You know what they say: when the boss is not there, the subordinate will do it. . . offer timely economic and market information. Send me an email: Aiden.reiter@ft.com.

The neutral type

Throughout this interest rate cycle, there has been much debate about the neutral rate, often called r*, or the long-term interest rate compatible with low inflation and full employment. Although it may seem a bit abstract, the neutral rate is important for markets and investors. It will help determine the pace at which investors and companies can access long-term capital and where money will flow as a result. And if the Fed exceeds r* while reducing interest rates in the coming months, inflation will return.

no coverage recently He noted that the Federal Reserve has been raising its consensus estimate for r*:

But that graph hides many disagreements. Dot plots at the Fed latest The summary of economic projections showed that Federal Reserve governors are divided on this figure. Estimates of r* ranged from 2.3 percent to 3.75 percent, with few estimates getting more than one vote. Compare that with June and MarchEstimates are more united, and it appears that the central bank is becoming less certain about the long-term neutral rate. If we add to this that the Laubach-Williams estimate, or the New York Federal Reserve’s r* estimate based on GDP and market data, is declining over the same period, the picture becomes more complicated:

This is not surprising. As we suggested two weeks ago, r* is very difficult to measure and is often seen as overshooting by the Fed, rather than cautiously tiptoeing into it. This is because, in essence, r* is the relationship between the level of investment and saving across an economy: if saving is too high among businesses, households, a government, or even foreign governments, r* must be reduced to encouraging investment and growth, and vice versa. Therefore, it is affected by almost every element of an economy, from population size to productivity to consumer confidence, and it is incredibly difficult to say which impacts will be the most profound.

seems more Economists agree with the Federal Reserve. that r* in the United States will be higher in the long run. To summarize some of the arguments:

• Recent experience: Despite the high rates of the last two years, the US economy has remained active. For some, this suggests that underlying patterns of investment and savings have changed and increased r*.

• New technologies: We are still in an investment campaign in artificial intelligence and green technology. Large private and government investments in these areas in the coming years will require higher rates to prevent the economy from overheating.

• Deglobalization: in a famous 2005 speechThen-future Federal Reserve Chairman Ben Bernanke observed that the growing U.S. current account deficit was evidence of a “global savings glut,” in which emerging economies with high savings rates were buying Treasury bonds. and American assets, due to lack of money. better investment opportunities in their economies or elsewhere. This resulted in greater availability of credit and higher savings in the US economy, meaning that the neutral rate remained low despite high short-term rates, rising asset prices, and low yields. Treasury bonds (referred to by Alan Greenspan, Bernanke’s predecessor at the Federal Reserve, as “the enigma”).

  But we now find ourselves in a period of deglobalization and declining global growth. Global slowdowns and rising tensions between the United States and China will hamper flows into American assets, and American savings will not be as strong as a result. As evidence of this, foreign holdings of US Treasuries have declined as a percentage of US GDP in recent years.

  The U.S. economy has also relied on cheap goods and services from China and emerging markets. If the United States becomes more protectionist in the future (potentially through Donald Trump’s proposed tariffs, a crackdown on Chinese overcapacity, or a war in Taiwan), prices could rise and the neutral rate would have to be higher. .

The market also seems to have accepted this argument. Long-term Treasury yields, which are a reflection of long-term inflation expectations, have trended higher since the pandemic:

But all of these arguments have potential flaws. To address them one by one:

• Recent experience: This cycle has been strange. Government stimulus and savings stifled by a once-in-a-century pandemic collided with supply shocks from an unexpected ground war in Europe. To expand on our phrase “a month is just a month”, “a cycle is just a cycle”.

• New technologies: The long-term result of the AI ​​investment craze would, in theory, be greater productivity, which could translate into greater savings, if more productive companies are able to make greater profits and then pass them on to their employees and investors. And investment could be lower in the long run if AI increases the marginal productivity gains from investment, meaning companies will need to invest less to earn more.

• Deglobalization: While the global savings glut may be declining, the U.S. economy and market have still outperformed its developed and emerging counterparts. The market remains liquid, US asset prices continue to rise beyond expectations and there is still huge global demand for US Treasuries and stocks. In other words, capital still has a hard time reaching the United States.

  We also don’t fully know the direction the relationship between the United States and China will take. If Beijing is able to launch green technologies and cheaper electric vehicles without clashing with Western nations, or if tariffs are implemented that match the prices of these technologies, rather than penalizing Chinese products, we could keep the inflationary outlook anchored.

in a blog post Last week, Ricardo Caballero, an economist at the Massachusetts Institute of Technology, raised another interesting point. He noted that sovereign debt has increased around the world, and that trend is likely to reverse in the United States and other countries as governments face pushback against rising deficits, either from voters or the market. . If governments are to recover their spending and stimulus, they may need to lower rates in the long term to stimulate domestic demand.

Demographics are also a confusing piece of the puzzle. Generally, economic logic – promoted by economists such as Charles Goodhart — is that as a population ages, r* will increase for two reasons. First, there will be a shortage of young labor, so wage competition will increase inflation. And secondly, a greater proportion of the population will spend their savings and pensions, resulting in investment exceeding savings.

But for some economists, that argument is in favor of an “aging” population, or one that has reached a critical mass of older people relative to younger workers. Before reaching that point, populations are “aging,” causing r* to be lower. As more people prepare for retirement, savings rates increase, especially as people worry about dwindling pensions. And before the demographics tilt too much toward seniors, many of them could choose not to spend their savings and instead pass them on to their children. Japan is a useful example here: it had negative rates for eight years, but only raised them last year, in part because competition over wages led to inflationary pressures.

It’s hard to say where the United States falls on the spectrum from “aging” to “aged,” making it difficult to draw conclusions about r*. A recent influx of immigration appears to have contributed to the broader demographic outlook. But earlier this year, the Congressional Budget Office reduced their fertility estimates, suggesting that the United States will become “aged” sooner rather than later, if it has not already done so.

In fact, r* may be higher, as the central bank and the market have suggested. But what we mean here is that there is no consensus among the Federal Reserve or economists, and there are many counterarguments to consider. Bernanke often referred to the Federal Reserve’s efforts as “learning as we go”; After this strange cycle, and with complex political, demographic and technological changes on the horizon, the Federal Reserve and investors should maintain that learning mindset.

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