Former Federal Reserve Vice Chairman: Neutral interest rates may not rise sharply

Former Federal Reserve Vice Chairman and Pimco Global Economic Advisor Clarida wrote an article in the Financial Times analyzing the Fed's interest rate trends. The full text is as follows.

After the Federal Reserve cut interest rates for the first time, the topic of discussion in the market has changed from “when” to start cutting interest rates to the “direction” of interest rates.

This shift isn't just a matter of semantics. The final level of interest rates matters to the entire economy. However, discussions often focus too narrowly on the neutral actual Federal Reserve policy interest rate, or R-star (hereinafter referred to as neutral interest rate for short). This refers to interest rates that neither stimulate nor inhibit economic growth.

Neutral interest rates mean that the economy can achieve the “Golden Girl” interest rate range, so that the economy can maintain price stability and maximize employment. While neutral interest rates are critical to understanding how monetary policy will evolve over the next few years, their estimates are imprecise. It is unobservable, changes over time, and is driven by domestic and global forces in the US.

Looking back at 2018, when the inflation rate reached the 2% target, the economy boomed with full employment. That year, the Federal Reserve raised the federal funds policy interest rate to 2.5%, which was converted to an actual interest rate of 0.5%, which is regarded by many as the “new” neutral level of monetary policy.

By contrast, before the global financial crisis, the average neutral interest rate was about 2%, and the federal funds rate hovered around 4%. Fast forward to today, the Federal Reserve's bitmap (policymakers' interest rate forecasts) shows that once the inflation rate stabilizes at 2% and the labor market is in a state of full employment, the federal funds rate target will reach around 3%.

I agree with the view that the neutral interest rate may rise from 0.5% before the pandemic, but I think this increase will be moderate. Others believe that neutral interest rates may be much higher than the Federal Reserve's predictions and financial market pricing by about 1% (that is, 3% minus 2%).

They pointed out that the factors that kept interest rates low before the pandemic have been reversed, America's fiscal outlook is worrying, and deficits and debt are rising. The US may also be on the verge of an AI-driven productivity boom, which could increase demand for US corporate loans.

So where is the real neutral interest rate? Of course, the US Treasury and private sector borrowers issue bonds along a complete yield curve, and historically, the slope of this yield curve is positive — interest rates rise over time to offset the risk of investors holding debt for longer periods of time. This is called a term premium.

An inversion of the US bond yield curve since the Federal Reserve's aggressive rate hike is rare, but it's not the new normal. As the Federal Reserve cuts interest rates and lowers “front-end” interest rates, the yield curve will be adjusted over the next few years to become steeper than before the pandemic, thus balancing demand and supply for US fixed income products. This is because bond investors will require higher maturity premiums to absorb surging bond issuances.

Like neutral interest rates themselves, term premiums cannot be observed and must be deduced from noisy macro and market data. There are two ways to do this.

The first method is to estimate the expected average of the federal funds rate over the next 10 years through a survey of market participants and compare this estimate with the actual yield on 10-year US Treasury bonds. According to a recent survey, the implied term premium using this method is estimated at 0.85 percentage points.

The second method uses a statistical model of the yield curve, which yields a present-term premium estimate of approximately zero. I personally prefer methods that rely on market participant surveys and believe that the current term premium is positive and is likely to continue to rise.

As the market must absorb a large and growing supply of bonds over the next few years, interest rates are likely to be higher than in pre-pandemic years. But I believe most of the necessary adjustments will be reflected by a steeper yield curve, rather than a sharp increase in the federal funds rate itself.

If I'm right, this bodes well for fixed income investors. They will be rewarded by taking interest rate risks when the economy is booming, and they will also benefit from the hedging value of the bonds in their portfolios when the economy is weak. At that time, interest rates will have more room to fall, thus increasing bond prices.