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Navigating the Uncertainty: The Federal Reserve’s Pursuit of the Neutral Interest Rate R*

Hannah Perry | October 25, 2024

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Where Will Rates End Up? Inside the Fed’s Chase for the Magic Number

The Quest for R-Star: Understanding the Neutral Rate of Interest

The Federal Reserve (Fed) is navigating its way through uncharted economic waters, with its focus increasingly centered on the concept of the neutral interest rate, commonly referred to as R*. This theoretical rate represents an equilibrium point in the economy where the supply of savings and the demand for investment align perfectly, resulting in stable inflation and full employment. For Fed officials aiming to ensure a soft landing for the U.S. economy in 2024 and 2025, finding this “magic number” is of utmost importance. However, the catch is that R* is not a figure that can be definitively measured in real-time; it only becomes somewhat observable in hindsight.

The Characteristics of R*

At its core, R* symbolizes a state of economic nirvana. A federal-funds rate set below this neutral level is said to provide a stimulative effect on the economy, while a rate above it is deemed restrictive. Unfortunately, there is significant uncertainty surrounding the actual value of R*, as policymakers continue to grapple with varying estimates. Recent updates from the Federal Open Market Committee (FOMC) indicate that the median forecast for the longer-run fed-funds rate has increased for three consecutive quarters, now standing at 2.9% as of September. Despite this, there remains a substantial discrepancy among predictions, with estimates ranging from 2.4% to 3.8%.

Federal Reserve Chair Jerome Powell emphasized this uncertainty during a press conference, stating, “I think we don’t know.” He acknowledged the challenge of pinpointing the neutral rate through model-based and empirical approaches, ultimately concluding that they will only recognize it by its effects.

Data Dependency and Market Implications

With the current target range for the fed-funds rate at 4.75% to 5%, which is significantly higher than most approximations of R*, the debate is largely theoretical at this stage. Yet, as rates approach estimates of neutrality, the conversations are likely to become heated. Market participants are eager to ascertain just how low the Fed might go in a scenario without a recession.

The Theoretical Foundations of R*

The concept of the neutral rate can trace its roots back to the late 19th century when Swedish economist Knut Wicksell introduced the idea of an economy-wide interest rate that neither propelled nor hindered price levels. Today’s methods take a more contemporary approach, including the Holston-Laubach-Williams (HLW) model, which gauges an economy’s maximum potential output in alignment with full employment and stable inflation. Interestingly, this model currently estimates a real neutral rate of around 0.7%, translating to a nominal rate of 2.7% when the Fed’s targeted inflation rate is considered.

According to recent assessments by Deutsche Bank economists, ten distinct estimates of the real neutral rate range from as low as 0.7% to as high as 2.5%, with an average of 1.5%. This implies that the fed-funds rate may find its way towards approximately 3.5%, suggesting a significantly higher neutral rate than what the U.S. economy experienced during the decade leading up to the pandemic.

Factors Influencing the Neutral Rate

There are both optimistic and pessimistic viewpoints regarding the potential for a higher post-pandemic neutral rate in the U.S. On the optimistic side, accelerated productivity growth could allow the economy to harness more output from existing resources. Notably, U.S. labor productivity witnessed a 2.7% increase in 2023, compared to a long-term average of only 1.5%. This rise in productivity could enhance returns on investment and subsequently increase demand for savings.

Technological innovations, particularly in automation and artificial intelligence, are poised to further revolutionize productivity. Olu Sonola, head of U.S. economic research at Fitch Ratings, points out that the surge in research and development investments post-pandemic is yet to fully translate into productivity gains. Meanwhile, the reshoring of supply chains is expected to catalyze higher investments today, leading to increased productivity down the line.

Nevertheless, there are countervailing forces that previously pressured the neutral rate downward prior to the pandemic. The aging global population, leading to a slower workforce growth and a rise in retirees who typically invest in safer, lower-return assets, stands as one significant factor.

The Debate Surrounding the Neutral Rate Theory

Critics such as Ed Yardeni, president of Yardeni Research, challenge the validity of the neutral rate theory, asserting that it should not guide monetary policy decisions. He argues that the Fed ought to address current economic conditions rather than conjecture about an elusive neutral rate. Yardeni offers a stark reminder: “It’s a fairy tale concept.” Indeed, while the Fed remains focused on the forecasted neutral rate, there remains a palpable tension between theoretical guidance and the practical realities of the economy.

In conclusion, as the Fed continues to seek R*, the economic landscape is fraught with uncertainties and contradictions. The outcome of this pursuit will play a pivotal role in shaping monetary policy and influencing the broader economy in the years to come. The quest for the magic number leaves both policymakers and market participants with much to ponder as they navigate the complexities of the current economic climate.