Fed's Neutral Rate Hope: Another Fatal Mistake?

• News
• 2024-09-21

If the Federal Reserve continuously lowers the federal funds rate in an attempt to reach a neutral interest rate, it risks reigniting inflation.

From early March 2022 to August 2024, Federal Reserve officials aimed to tighten monetary policy sufficiently to reduce inflation, despite widespread expectations that this would lead to a recession. Today, they have succeeded in doing so, and a recession has not materialized.

The inflation rate is approaching 2%, and policymakers aim to prevent an increase in the unemployment rate. They intend to achieve this by lowering the federal funds rate to a neutral level, at which inflation remains low and unemployment remains low. This level is commonly referred to by economists as the neutral interest rate (R-star or R*).

The issue is that the U.S. economy had almost achieved this goal before the Federal Open Market Committee (FOMC), which sets policy, cut the federal funds rate by 50 basis points to 4.75% to 5.00% on September 18. Furthermore, the FOMC hinted at more easing policies in the future in its Summary of Economic Projections (SEP) for its committee members.

The SEP shows that policymakers' median forecast for the "long-term" neutral federal funds rate is 2.90%. They collectively believe that, in the long term, this will be consistent with a 4.2% unemployment rate and a 2% inflation rate. This implies an actual neutral federal funds rate of 0.9%, significantly lower than the current level.

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Of course, the neutral federal funds rate is entirely a theoretical concept. Everyone acknowledges that it cannot be measured and will change over time, depending on many economic factors. Even the FOMC's estimates for this long-term rate vary from 2.37% to 3.75%.

Federal Reserve officials were undoubtedly shocked by the clear weakness in the labor market shown by the data released before the September FOMC meeting. However, data released after the meeting showed that job growth in September was stronger than expected, with revisions to the number of jobs in July and August. Additionally, the unemployment rate fell back to 4.1%.

Meanwhile, the "super core" inflation rate in September (core services excluding housing) remains well above 2.0%. At the end of 2022, Federal Reserve Chairman Powell stated that this "may be the most important indicator for understanding the future evolution of core inflation."

So, why have several Federal Reserve officials indicated that they remain committed to further rate cuts? Apparently, they believe that, given the significant decline in inflation since the summer of 2022, they must lower the nominal federal funds rate to prevent the real rate from rising and becoming too restrictive. They want it to fall in line with their estimates of the real neutral rate. They are concerned that if the real rate is allowed to rise, the inflation rate will fall below 2%, and the unemployment rate could soar. Thus, they are targeting an unknown neutral rate.

The bond market's reaction to the Federal Reserve's massive rate cut on September 18 is quite telling. The yield on the 10-year U.S. Treasury note has risen strongly compared to U.S. Treasury Inflation-Protected Securities, and the increase in the inflation premium has already been reflected in the market's pricing.This raises another question regarding the correlation of the neutral interest rate after inflation adjustment. Federal Reserve officials intend to lower the federal funds rate because actual inflation has slowed down. However, their initial move seems to be raising inflation expectations in the bond market. Most economists seem to agree that, theoretically, the neutral interest rate should be adjusted based on expected inflation rather than actual inflation.

Federal Reserve officials appear to be committed to a series of rate cuts to bring the federal funds rate down to neutral, regardless of where its final level is.

While fiscal policy will inevitably have some impact on the neutral interest rate, Federal Reserve officials seem to believe that only monetary policy matters. Relying on the neutral interest rate does not solve the problems of fiscal policy.

The huge federal deficits of the past few years help explain why the economy did not fall into recession when the Federal Reserve tightened monetary policy. However, inflation has subsided. If the nominal and real neutral interest rates are therefore much higher than what Federal Reserve officials believe? Then inflation could make a comeback as the Federal Reserve continues to lower the federal funds rate. The message from the bond market to Federal Reserve officials is to be wary of your reliance on the neutral interest rate.