The Fed's Balancing Act: Navigating the Shifting Neutral Rate Landscape

The US Federal Reserve's recent policy decision to cut interest rates by half a percentage point has sparked a flurry of discussions around the future trajectory of interest rates. As the central bank grapples with the complexities of the economic landscape, the key question remains: where will rates ultimately land once the dust settles?

Uncovering the Shifting Sands of the Neutral Rate

Recalibrating the Neutral Rate Estimate

The Federal Reserve's Summary of Economic Projections has revealed a shift in the median respondent's view of the "longer-run" federal funds rate, now estimated to be around 2.9%, up from the previous estimate of 2.8%. This rate is considered the level that will prevail in a balanced economy with a strong labor market and low, stable inflation. Historically, policymakers had pegged the neutral rate around 2.5%, or 0.5% in "real" terms after adjusting for inflation. However, these estimates have drifted higher, and some experts, such as former New York Fed President Bill Dudley, believe the neutral rate could be as high as 3% to 3.5%, or even 4%.

Factors Influencing the Neutral Rate Shift

The upward revision in the neutral rate estimate can be attributed to the economy's resilience in the face of the Fed's aggressive rate hikes. Contrary to expectations, the US GDP continued to expand at around 2.5%, and the unemployment rate remained below 4%, suggesting that the policy may not have been as restrictive as previously thought.Additionally, the lingering effects of the pandemic, such as excess savings and ultra-low mortgage rates, have provided a cushion for households, masking the full impact of the rate increases. However, as these temporary factors fade, the true impact of the Fed's actions is becoming more apparent, with the unemployment rate climbing from 3.4% in early 2023 to 4.2%.

The Elusive Nature of the Neutral Rate

Fed Chair Jerome Powell acknowledged the inherent challenges in pinpointing the neutral rate, stating that it is determined by its "works" – the real-world outcomes observed in the economy. He noted that while there are model-based and empirically-based approaches to estimating the neutral rate, the reality is that it remains a moving target, subject to various economic forces and uncertainties.Powell also expressed skepticism about the likelihood of a return to the near-zero interest rate environment seen during the financial crisis and the COVID-19 pandemic, suggesting that the neutral rate is now "significantly higher" than it was back then. However, he conceded that the exact level of the neutral rate is still unknown, and the Fed will have to "find out" as it navigates the evolving economic landscape.

Implications for the Bond Market

The upward shift in the neutral rate estimate has significant implications for the US bond market. Longer-term bond yields, such as the 10-year Treasury note, are unlikely to see substantial declines in the near term unless the economy experiences a material weakening. This is evident from the fact that yields on the 10-year Treasury note actually rose by five basis points after the Fed's recent rate cut decision.The bond market's reaction underscores the notion that the party may be coming to an end, at least for now. With the Fed's rate-setting committee projecting a higher neutral rate, longer-term bond yields are likely to find a floor, limiting the potential for significant declines in the foreseeable future.

Celebrating the Taming of Inflation

Despite the challenges surrounding the neutral rate, the Federal Reserve's policy decision on Wednesday should be celebrated as a significant milestone in the fight against inflation. The size of the rate cut, a half-percentage point reduction, is a clear signal that the central bank is committed to supporting the labor market and mitigating any meaningful economic weakening.Moreover, the fact that the Fed is able to ease policy at this stage suggests that the "inflation dragon" has been largely tamed. This is a testament to the central bank's unwavering efforts to bring price pressures under control, even as it navigates the complexities of the shifting neutral rate landscape.As the US economy continues to evolve, the Federal Reserve will undoubtedly face ongoing challenges in determining the appropriate monetary policy stance. However, the latest developments in the neutral rate debate underscore the central bank's commitment to striking a delicate balance between supporting economic growth and maintaining price stability – a task that will require vigilance, flexibility, and a deep understanding of the ever-changing economic dynamics.