The problem with fixing the neutral rate

Stay up to date with free updates

Simply sign up to US interest rates myFT Digest — delivered straight to your inbox.

This article is an on-site version of our Unhedged newsletter. Premium subscribers can sign up here to receive the newsletter delivered every day of the week. Standard subscribers can upgrade to Premium here or explore all FT newsletters

Good morning. US dockers went on strike on Monday. If no deal is reached in the coming weeks, a quarter of US trade could grind to a halt and inflation could start to rise again. How will the Federal Reserve and the market respond to another supply shock, as the previous one seemed to be in the rearview mirror? Rob is away for the rest of the week, so you’re in my hands today. You know what they say: when the boss is gone, the underling will . . . provide timely market and economic information. Email me: [email protected].

Neutral rate

Throughout this interest rate cycle, there has been a lot of talk about the neutral rate, often called r*, or the long-term interest rate consistent with low inflation and full employment. Although it seems a bit abstract, the neutral rate matters to markets and investors. It will help determine the rate at which investors and companies can access long-term capital and where money will flow as a result. And if the Fed exceeds r* as it cuts interest rates in the coming months, inflation will rebound.

Unhedged recently noted that the Fed raised its consensus estimate for r*:

But that chart hides a lot of disagreement. Dot charts from the Fed’s most recent summary of economic forecasts showed Fed governors split on that number. Estimates for r* ranged from 2.3% to 3.75%, and few estimates received more than one vote. Compare this to the more dovish estimates in June and March, and it looks like the central bank is becoming less certain about the long-term neutral rate. Add to this that the Laubach-Williams estimate, or the New York Fed’s estimate of r*, based on GDP and market data, has been declining over the same time period, and it paints a complicated picture:

This is not surprising. As I suggested two weeks ago, r* is very hard to measure and is often found by the Fed running over it rather than cautiously tiptoeing towards it. This is because r* is essentially the relationship between the level of investment and saving in an entire economy: if saving is too high among companies, households, a government or even foreign governments, r* must fall to stimulate investment and growth and vice versa. It is therefore 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.

Most economists seem to agree with the Fed that r* in the US will be higher in the long run. To summarize some of the arguments:

• Recent experience: Despite the high rates of the past two years, the US economy has remained hot. This suggests to some that underlying investment and savings patterns have changed and increased r*.

• New technologies: We are still in an investment blitz for artificial intelligence and green technology. Major private and government investment in these areas in the coming years will require higher rates to stop the economy from overheating.

• Deglobalization: In a famous speech in 2005, then-future Federal Reserve Chairman Ben Bernanke observed that the growing US current account deficit was evidence of a “global savings glut,” in which emerging economies with high savings rates were buying US Treasuries and assets — for lack of better investment opportunities in their savings or elsewhere. This has led to more available credit and higher savings in the US economy, meaning that the neutral rate has remained low despite high short-term rates, high asset prices and low Treasury yields (at which referred to by Alan Greenspan, Bernanke’s predecessor at the Fed, as an “enigma”).

  But now we are in a period of deglobalization and declining global growth. Global slowdowns and rising tensions between the US and China will hinder flows to US assets, and US economies will not be as robust as a result. As evidence, foreign holdings of US Treasuries have declined as a percentage of US GDP over the past several years.

  The US economy also relied on cheap goods and services from China and emerging markets. If the US 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 should be higher.

The market seems to have accepted this argument as well. Long-term Treasury yields, which are a reflection of long-term inflationary expectations, have risen 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 from a once-in-a-century pandemic collided with supply shocks from an unexpected land war in Europe. To extend the phrase “a month is just a month”, “a cycle is just a cycle”.

• New technologies: The long-term result of the AI ​​investment frenzy would theoretically be greater productivity, which could translate into greater savings if more productive companies are able to capture greater gains 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 have to invest less to earn more.

• Deglobalization: While the global savings glut may be waning, the US economy and market have continued to outperform their developed and emerging market counterparts. The market remains liquid, US asset prices continue to rise above expectations and there is still excessive global demand for US Treasuries and stocks. In other words, capital is still struggling to get to the US.

  We also do not fully know the direction of travel of the US-China relationship. If Beijing is able to roll out cheaper green technologies and electric vehicles without clashing with Western nations, or if tariffs are implemented that equalize the prices of these technologies rather than penalize Chinese goods, we could keep the inflationary outlook anchored.

In a blog post last week, Massachusetts Institute of Technology economist Ricardo Caballero made another interesting point. He noted that sovereign debt has risen around the world, and that trend is likely to reverse in the US and elsewhere as governments face pushback from growing deficits, either from voters or the market. If governments need to recover their spending and stimulus, they may have to lower long-term rates to boost domestic demand.

Demographics are also a confusing piece of the puzzle. In general, the economic logic—promoted by economists such as Charles Goodhart—is that as a population ages, r* will increase for two reasons. First, young labor will be less available, so wage competition will increase inflation. And second, a greater proportion of the population will spend on their nest eggs and pensions, leading to investment outstripping savings.

But for some economists, that argument is for an “aging” population, or one that has reached a critical mass of older people relative to younger workers. By that time, the populations are “aging”, causing r* to decrease. As more people prepare for retirement, savings rates rise, especially as people worry about shrinking pensions. And before the demographics shift too much toward the elderly, many of the elderly may choose not to spend their savings and instead pass it on to their children. Japan is a useful example here: It had negative rates for eight years, but just last year it raised rates, in part because wage competition led to inflationary pressures.

It’s hard to tell where the US is on the spectrum of “obsolete” to “aging,” making it difficult to draw conclusions about r*. A recent influx of immigration appears to have helped the broader demographic outlook. But earlier this year, the Congressional Budget Office lowered its fertility estimates, suggesting the U.S. will transition to “aging” sooner rather than later — if it’s not already there.

r* may indeed be higher, as the central bank and the market have suggested. But our point here is that there is no consensus among the Fed or economists, and plenty of counterarguments to consider. Bernanke would often refer to the Fed’s efforts as “learning as we go”; After this strange cycle, and with complex political, demographic and technological changes on the horizon, the Fed and investors should maintain this learning mindset.

A Good Read

Just a great celebrity profile.

FT Unhedged Podcast

Can’t get enough of Unhedged? Listen to our new podcast for a 15-minute dive into the latest market news and financial headlines, twice a week. Keep up to date with previous editions of the newsletter here.