Fed seeks to find where neutral ‘phantom threat’ rate lies

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Federal Reserve Chairman Jerome Powell and his colleagues are on the march to return ultra-loose monetary policy and accommodative financial conditions to more normal levels. The problem is that their fate is uncertain and the ground may be changing as they push higher interest rates.

Policymakers differ on what the neutral rate is, the rate that neither constrains nor stimulates economic growth, and express it in terms that do not take into account the current environment of high inflation. And they aren’t sure what effect the removal of monetary largesse will have on fickle financial markets and an economy that has grown accustomed to ultra-low rates.

“I doubt anyone can confidently say where the neutrality is,” said Allianz SE chief economic adviser Mohamed El-Erian.

That raises the risk that the Fed will make a policy mistake, either by raising rates too high and pushing the US into recession, or by not raising them enough and allowing high inflation to become endemic.

Stifel Nicolaus & Co. Chief Economist Lindsey Piegza estimates the risk of an economic contraction in the next 21 months exceeds 50% as the Federal Reserve tightens credit in a slowing economy. Roberto Perli of Piper Sandler & Co. acknowledges that for the past 35 years the economy faltered almost every time the Fed reached or exceeded neutral.

In his first speech at the Fed’s annual Jackson Hole conference in 2018, Powell highlighted the uncertainties surrounding economic concepts like the R-star or the neutral rate, saying they are imprecise and subject to revision.

The location of the R-star is often so difficult to define that St. Louis Fed President James Bullard once referred to it as “The Phantom Menace,” using a line from Star Wars. It can be influenced by forces such as demographics, inequality, savings, inflation expectations, productivity, and the fabric of the labor market, all of which are sometimes difficult to interpret in real time.

The Fed’s push toward higher rates received a further boost on Friday with the release of another strong jobs report. The United States added 431,000 jobs in March, while the unemployment rate fell to 3.6%, close to its pre-pandemic low, according to the Labor Department.

After raising rates from near zero by a quarter of a percentage point in March, Powell & Co. have indicated they are willing to move quickly toward a more normal environment for monetary policy, and perhaps beyond, where the level of rates slows down the economy and slows growth.

As set out in their Summary of Economic Projections released March 16, policymakers’ median forecast sees the fed funds rate rising to 1.9% by the end of this year and 2.8% by the end of 2023.

Policymakers can probably band together to make two or three 50 basis point hikes in the short term because everyone agrees rates are too far below neutral and inflation is too high, said Vincent Reinhart, chief economist. of Dreyfus and Mellon.

But as rates move closer to more normal levels, it may be more difficult to build a consensus moving forward, especially if Chairman Joe Biden’s yet-to-be-confirmed nominees for the Fed board turn out to be as dovish as expected, Reinhart said. . Economists at Goldman Sachs Group Inc. and Citigroup Inc. are among those who see the Fed’s rate peaking at 3% or more.

One problem, according to Philadelphia Fed President Patrick Harker: “We don’t even agree on what is neutral.” Estimates of the SEP for the neutral star, or so-called R star, range from 2% to 3%, with a median of 2.4%.

Those estimates are based on inflation being at the Fed’s 2% target. It’s well above that now: The personal consumption expenditures price index, the Fed’s favorite gauge of inflation, rose 6, 4% in February compared to the previous year. And it’s expected to be about 3% over the next five years, according to Treasury Securities Trading.

That suggests the neutral rate the Fed is targeting is above 3%, not comfortably below it, according to former Fed Vice Chairman Donald Kohn.

To further complicate the picture: the US central bank plans to start shrinking its $8.9 trillion balance sheet sometime in the next few months. Harker said in a March 29 webinar that a $3 trillion reduction in the balance sheet over time would be equivalent to about two quarter-percentage-point increases in the fed funds rate, though he stressed there was a lot of uncertainty. around that estimate.

However, what ultimately matters for the economy is not the level of the fed funds rate per se, but the financial conditions it creates through changes in the prices of stocks, bonds, and other assets. Those changes affect the ability and willingness of consumers and businesses to borrow and spend and thereby shape the course of the economy.

“It’s a bit of a mystery what’s going on” in financial markets, Kohn said. Financial conditions have tightened since the Fed moved in a more aggressive direction, but not by much. Treasury yields have risen, but inflation-adjusted real rates remain negative. Stock prices have fallen, but they are not that far from all-time highs.

What Bloomberg Economists Say

“The Fed raises at each meeting for the rest of 2022, with a movement of 50 basis points”, taking the reference index to a range of 2% to 2.25% by the end of the year, with one more percentage point of adjustment in 2023.

— Anna Wong, Chief US Economist

Kohn, who is a senior fellow at the Brookings Institution, suggested financial markets may need to weaken further to help the Federal Reserve align demand in the economy with supply and bring down inflation. “There could be some interesting times ahead in financial markets,” he said at a March 30 webinar convened by the American Enterprise Institute.

Because markets have gotten so hooked on ultra-loose monetary policy, it’s hard to know how they’ll react when rates rise, said El-Erian, a columnist for Bloomberg Opinion. That, in turn, is why the level of the neutral fed funds rate is so hard to pin down.

But it’s where they say policymakers are headed, even if not everyone agrees on exactly what that entails.

“Clearly, we need something more normal or neutral, whatever that means,” New York Fed President John Williams told an audience in Princeton, New Jersey, on Saturday.

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