A global hunt for neutral to shape world financial costs By Reuters

By Howard Schneider and William Schomberg

WASHINGTON/LONDON (Reuters) – With key central banks now aligned to cut interest rates, a real-time experiment is underway on how much the global financial landscape has changed since the pandemic, and in particular whether the easing cycle can be short duration due to higher base rates.

The impact of the Federal Reserve last week joining a process already under way at the European Central Bank, the Bank of England and elsewhere with a half-point cut larger than anticipated could be widening — already credited by some analysts for that opened the way. for the People’s Bank of China to unveil its biggest stimulus since the pandemic, with fewer concerns about how it might affect local currency values.

But how much and how far the global easing can continue remains unknown as policymakers explore whether the rates needed to keep inflation under control and economies growing are higher now than the ultra-low ones common before the pandemic.

Officials in Washington, Frankfurt and London are skeptical that they can specify that “neutral” interest rate other than by seeing how economic conditions evolve as rates fall, a difficult exercise that probably involves gut and intuition as much as math and modeling.

They agree, however, that it is likely higher than before, a conclusion that at some point will prompt officials to move more cautiously toward further rate cuts.

Referring to the years before the pandemic, when the Fed rate was close to zero for years and Europe entered the exotic world of negative rates, Fed Chairman Jerome Powell said last week that he felt the world had gone for good.

“It’s so far gone now, my feeling is we’re not going to go back to it,” Powell said. “To me I feel like the neutral rate is probably significantly higher than it was then. How high is it? I just don’t think we know… We only know by his papers.”

Those “works” would include inflation at the 2 percent target shared by all major central banks, and an unemployment rate, wage growth, and economic growth close to potential consistent with that rate of price growth.

Among the major central banks, only the Bank of Japan is not easing monetary policy to address this point, instead tightening it after it finally managed to lift inflation.

For the Fed, in projections issued last week, the median stopping point for rate cuts seen by officials was 2.9 percent, to be reached by the end of 2026. But individual projections ranged from 2.4% to 3.9%.

Fed Governor Michelle Bowman notably argues that the neutral rate is “much higher than it has been” and therefore the Fed is closer than suspected to its theoretical stopping point.

“THE WORLD HAS CHANGED”

How the data and the debate around it play out in the coming months will be key to a global reset in the cost of borrowing to finance a home, buy a car or build a business. In the US, mortgage rates for a 30-year home loan were often around 3% in the decade before the pandemic and have risen to nearly 8% as the Fed has tightened policy.

They are already down to 6%, but the decline is unlikely to be as steep as the rise. A recent Fed study suggested that mortgage rates may not fall below 5%.

So it can be worldwide.

The ECB’s governing council does not have a neutral estimate for the rate, but staff published a paper this year showing it was around 2%, compared to near or slightly below zero before the pandemic.

The BoE does not publish a precise estimate of what it thinks could be neutral. But the bank’s latest survey of market participants showed analysts had seen it at 3.5%.

In August, after the BoE cut interest rates to 5.0% for the first time after 2020 from their 16-year high of 5.25%, BoE Governor Andrew Bailey, like Powell, said the level of low rates probably ended.

“We’re unlikely to go back to the world we were in between 2009, after the financial crisis, and when we started raising rates,” Bailey said. “The reason for this is that the world has really been driven by very large shocks” that have affected commodity markets and labor markets, changed the dynamics of global supply and investment, and been shaped by fiscal initiatives that included new-style industrial policy in US.

These factors, along with demographic, productivity and other underlying trends, likely mean more intense price pressures and higher interest rates going forward, Jason Thomas, head of global research and investments for Carlyle, wrote in a recent analysis.

“Central banks do not set policy in a vacuum or under self-selected circumstances,” he said. “The world has changed since 2019 in ways likely to ensure that price pressures emerge before interest rates approach pre-pandemic levels.”