For the Fed, destination matters far more than pace

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Good morning. I guess smart companies with bad news to share issue hidden press releases at 2.35pm on Fed meeting days, knowing all the financial journalists will be called on the Jay Powell show. Let us know if we missed anything juicy yesterday: [email protected] and [email protected].

50 basis points, followed by nothing

The headlines were flashed; pundits donned make-up and appeared on cable television; secondary bets have proliferated; column centimeters stretched to the moon; analyst notes piled up in tottering piles; social media lit up like a video game. And in the end the market was hilariously unimpressed. We were down 50bps and stocks, bonds and currencies shrugged their shoulders in what appeared to be a deliberate effort to humiliate the financial punditocracy.

This indifference wasn’t just funny. It was also a fitting end to the will-be-25-or-will-be-50 kerfuffle. Once the Fed decisively signaled its pivot to tapering, what mattered most was not the pace, but the destination. A quarter-point difference in a single short-term interest rate is, in isolation, of little importance to the economy as a whole. What matters about the size of a particular cut at a particular time is what it signals about the central bank’s extended journey: where it thinks rates need to be and when it thinks they need to get there.

Which brings us to the neutral rate (or r*, if you like the jargon): the unobservable level of rates that is consistent with full employment and low inflation. “We only know her by her works,” President Powell likes to say, misquoting the Gospel of Matthew. He said it twice at yesterday’s press conference. You have fallen below the neutral rate when inflation rises; you rose above it when risky assets withered and unemployment rose. Meanwhile, you walk around in the dark, speculating when you might fall off a ledge or, alternatively, hit your head. In general, central bankers can’t sit still either. Economies have momentum and politics is running late. The Fed needs to make an estimate and trip over it.

The Fed’s current estimate for the neutral rate is 2.9%, according to its summary of economic forecasts, up a tenth of a percentage point from the last SEP in June. That may not sound like much of a change, but if you look at a slightly longer time frame, the Fed has changed its view considerably:

This shift is consistent with a developing economic consensus that fiscal and monetary stimulus, aging populations, deglobalization, higher productivity and other factors are pushing the neutral rate up. The practical significance of the change is that the Fed doesn’t have that far to go to what it (as of now) thinks is its destination. If it moves 50bp per meeting, it will be close to the target in March next year (of course the intention is to go at a much more imposing pace if circumstances allow).

If the neutral rate is closer now, why move 50bp? Yesterday’s Fed response: Because we can. The theme of the press release and press conference was that the excellent progress in inflation allowed for a large but preemptive reduction. We believe the labor market is fine, and with inflation nearly accelerating, we can act to make sure it stays that way. Unhedged, for its part, thinks the Fed is right about this. It is likely that inflation it is all but whipped, and that the economy it is ok, so a 50bp reduction in itself is low risk. But we don’t know, and probably no one does, where the neutral rate is. All we know is we’re 50 bp closer to that now and we’re closing.

For most investors, this matters primarily because of the possibility of a Fed error. If the Fed goes too far, inflation reignites and it becomes clear that the Fed will have to raise interest rates again, it will want to hold (to greatly simplify) stocks rather than Treasuries. If it doesn’t go far enough, and declining employment leads to a recession, the opposite bet is correct. Active investors have no choice at this point in the cycle to have their own view of where the neutral rate is so they can decide what kind of mistake the Fed is more likely to make. This is much more important than the size of the next cut. But 25 vs 50 is a nice, well-defined debate, while estimating the neutral rate is a college economics seminar where the syllabus is secret, the exam date is unknown, and your grade determines your salary.

The stakes are especially high now because risk asset prices are so stretched. Stocks, especially large US stocks, are at high multiples of earnings and credit spreads are as tight as they get. This means that things are valued for stability, and a central bank that has to change course quickly because it has gone above or beyond the neutral rate is the exact opposite of stability. You are betting on r* whether you know it or not.

A good read

Spies on ice.

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