The Federal Reserve on Wednesday began its policy easing with a bang. Much of the focus was on its decision to cut interest rates by half a percentage point from a two-decade high. But the key question for the bond market is where rates will land once all is said and done. Nobody knows for sure, and Chair Jerome Powell injected enough uncertainty to ensure a choppy ride ahead.
The Fed’s Summary of Economic Projections showed that the median respondent among Federal Reserve Board members and Federal Reserve Bank presidents now sees the “longer-run” federal funds rate landing at around 2.9%, up from about 2.8% in its previous quarterly update. That’s the rate that policymakers think will prevail in a balanced economy with a strong labour market and low and stable inflation.
For years, policymakers thought that “neutral” was around 2.5% (or 0.5% in “real” terms, adjusting for inflation at 2%). Not only have their estimates drifted higher, but I suspect that they could climb a bit more to converge with the median private sector estimate of 3.1% in the Federal Reserve Bank of New York’s survey of primary dealers. My Bloomberg Opinion colleague Bill Dudley, the president of the New York Fed from 2009-2018, told me Wednesday that neutral is probably around 3% to 3.5% — and could be as high as 4%.
The upshot is that longer-term bond yields don’t have much room to fall in the near-term unless the economy weakens materially. The developments help explain why yields on the 10-year Treasury note actually rose by five basis points after the Fed’s decision.
In theory, “neutral” is believed to be a function of slow-moving factors including demographics and productivity, but it’s very hard to know what it is in real time. Estimates of the rate started to increase meaningfully in 2023, in large part because the economy didn’t react as expected to the Fed’s aggressive rate increases. The assumption was that if you could raise rates from near zero to 5.25%-5.5% and still have gross domestic product expanding at around 2.5% and an unemployment rate below 4%, perhaps policy wasn’t as “restrictive” as people previously thought.
Of course, it’s also important to distinguish short-term factors from longer-run ones: At the time, millions of households were still reaping the benefits of excess savings and ultra-low pandemic-era mortgages. But those aren’t permanent features of the US economy, and, since then, the unemployment rate has climbed from 3.4% in early 2023 to 4.2%. In other words, it’s getting harder to argue that the rate hikes aren’t working at all. There’s still a decent argument for a higher neutral rate, but it’s a moving target.
Powell acknowledged as much at his press conference, in response to a question from Christopher Rugaber of the Associated Press:
There are model based approaches and empirically based approaches that estimate what the neutral rate will be at any given time. But realistically we know it by its works.
He also gave this response to Fox Business journalist Edward Lawrence concerning the odds that policy rates would return to the near-zero levels seen after the financial crisis and during the Covid-19 pandemic (emphasis mine):
Intuitively many, many people would say we’re probably not going back to that era where there were trillions of dollars of sovereign bonds trading at negative rates, long-term bonds trading at negative rates… and it looked like the neutral rate might even be negative… It seems that’s so far away now. My own sense is that we’re not going back to that. But you know honestly, we’re going to find out. But it feels to me that the neutral rate is probably significantly higher than it was back then. How high is it? I just don’t think we know. Again, we only know it by its works.
All in all, there’s plenty worth celebrating in Wednesday’s Fed announcement. It’s a signal that the inflation dragon has been mostly slain. The size of the cut is a reminder that policymakers stand ready to support the labour market and head off any meaningful economic weakening. But over in the bond market, it sure looks like the party is just about over (at least for now). Members of the Fed’s rate-setting committee think that neutral interest rates are a bit higher than before, and that puts a floor under longer-term bond yields for the foreseeable future.
Credit: Bloomberg
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