Where Will Rates End Up? Understanding the Fed’s Quest for the Neutral Rate

The Quest for R-Star: A Theoretical Tightrope

The Federal Reserve is grappling with one of the most elusive concepts in economics: the neutral rate of interest, known as R*. This theoretical yardstick, which represents the interest-rate level struck in perfect economic balance, serves as the guiding principle for Fed officials as they aim for a soft landing for the U.S. economy in 2024 and 2025. However, herein lies the catch—no one knows what the neutral rate truly is, leading to considerable uncertainty and debate.

Defining R*: An Economic Nirvana

R* denotes an economic equilibrium where the supply of savings matches the demand for investment, the labor market achieves full employment, and inflation remains stable. Essentially, this is the economic utopia every policymaker dreams of. When the federal-funds rate is below this theoretical neutral rate, the economy receives a stimulative boost. Conversely, a higher fed-funds rate is deemed restrictive. The problem is not just measuring R*; it’s determining its very existence.

The Disagreement Among Policymakers

Despite their intentions, Federal Open Market Committee members remain divided on the true level of the neutral rate. The September update to the quarterly Summary of Economic Projections revealed a median forecast for the longer-run fed-funds rate at 2.9%, but this figure masked a broader disagreement. Estimates varied significantly, with projections ranging from 2.4% to 3.8%—a discrepancy of over a percentage point. “I think we don’t know,” admitted Fed Chair Jerome Powell at a recent press conference, highlighting the inherent uncertainty that plagues the central bank’s decision-making.

Current Context: Fed-Funds Rate at a High

Presently, the fed-funds rate sits between 4.75% and 5%, far above most estimates of R*. This leans toward an academic exercise—at least for now. However, the situation becomes more fraught as rates draw nearer to neutral, where marketplace speculation about interest-rate cuts in a no-recession scenario will heat up.

A Historical Perspective on the Neutral Rate

The conceptual origins of the neutral rate date back to the late 19th-century research of Swedish economist Knut Wicksell, describing the interest levels that neither raise nor lower commodity prices. Modern models, such as the Holston-Laubach-Williams model, focus on maximizing potential output consistent with full employment and stable inflation. Currently, this model suggests an inflation-adjusted neutral rate around 0.7%, translating to about 2.7% when factoring in the Federal Reserve’s target inflation rate.

The Divergence of Estimates

Deutsche Bank’s recent compilation of neutral rate estimates spans from 0.7% to 2.5%, yielding an average of 1.5%. This points toward a higher equilibrium in contrast to the near-zero rates experienced during the post-financial crisis era, when sluggish economic growth and tame inflation persisted.

Factors Influencing a Higher Neutral Rate

Several factors could suggest a higher post-pandemic neutral rate for the U.S. economy. On a positive note, faster productivity growth has emerged as a likely driver, enabling the economy to extract more output from existing labor and resources. In 2023, U.S. labor productivity increased by 2.7%, significantly outperforming the 1.5% annual average seen over the last two decades. Technological advancements, particularly in automation and artificial intelligence, promise further contributions to productivity in the years to come.

Investment trends are also shifting thanks to reshoring supply chains, with an emphasis on modern factories that utilize automation technologies. Additionally, enhanced spending on green initiatives and national defense will boost investment opportunities, contributing to an increased neutral rate.

Compounding Pressure from U.S. Debt

Yet, compounding this is the federal government’s persistent deficits projected to exceed 6% of GDP. Whichever party occupies Washington post-election, a balanced budget remains unlikely in the near future, thereby increasing demand for savings.

The Counterarguments: A Cautionary Outlook

On the opposing side, the neutral rate theory faces skepticism from various economists. Ed Yardeni of Yardeni Research has publicly denounced the concept as a “fairy tale,” arguing that the Fed ought to synchronize its approach with current economic realities rather than speculate on theoretical benchmarks. The existing economic environment, he asserts, has thrived even with a 5.5% fed-funds rate.

A Conservative Perspective

As conservatives, we advocate for sound money and stable economic growth. The Fed’s current method of grappling with R* and its uncertainties risks not just stunted growth but turbulent market conditions. Policymakers must acknowledge the necessity of traditional fiscal responsibility while pursuing growth through robust investments in the domestic economy – a challenge made all the more crucial in light of our nation’s spiraling debt.

In summary, the Federal Reserve’s pursuit of the mystical R* rate presents a formidable challenge. The interplay of rising productivity, ongoing investment shifts, and fiscal responsibility must be recognized in any serious discourse about the future of U.S. interest rates. A clear-eyed focus on sustainable economic growth—beyond mere theorizing—will be essential as we navigate this uncertain landscape.