The trouble with pinning down the neutral rate

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Good Morning. US dock workers started to strike on Monday. If no deal is reached in the coming weeks, a quarter of US trade could grind to a halt, and inflation could start to rear its ugly head again. How will the Federal Reserve and the market respond to a new supply shock, just as it looked like the previous one was in the rear-view mirror? Rob is out for the rest of the week, so you are in my hands today. You know what they say: when the boss is away, the underling will . . . deliver timely market and economic insights. Email me: [email protected].

The neutral rate

Over the course of this interest rate cycle, there has been a lot of discourse about the neutral rate, often called r*, or the long-run interest rate consistent with low inflation and full employment. Though it seems a bit abstract, the neutral rate matters for the markets and investors. It will help determine the rate at which investors and companies can access capital in the long-run, and where money will flow as a result. And if the Fed overshoots r* as it brings down interest rates in the coming months, inflation will stage a comeback.

Unhedged recently observed the Fed has been raising its consensus estimate for r*:

But that graph hides a lot of disagreement. The dot plots in the Fed’s most recent summary of economic projections showed the Fed’s governors are split on this number. Estimates of r* ranged from 2.3 per cent to 3.75 per cent, and few estimates got more than one vote. Compare that to June and March’s more united estimates, and it seems that the central bank is getting less certain about the long-run neutral rate. Add to this that the Laubach-Williams estimate, or the New York Fed’s r* estimate based on GDP and market data, is decreasing over the same time period, and it makes for a complicated picture:

This is not surprising. As we suggested two weeks ago, r* is very difficult to measure, and is often found by the Fed blowing past it, rather than cautiously tiptoeing towards it. This is because, at its core, r* is the relationship between the level of investment and savings across an entire economy: if savings are too high among companies, households, a government, or even foreign governments, r* needs to come down to incentivise investment and growth, and visa versa. It is therefore impacted by almost every element of an economy, from population size, to productivity, down to consumer confidence, and it is incredibly hard to tell which impacts will be the deepest.

It seems most economists agree with the Fed that r* in the US is going to be higher in the long run. To sum up a few of the arguments:

• Recent experience: Despite high rates over the past two years, the US economy has remained hot. This suggests to some that underlying investment and savings patterns have shifted and raised r*.

• New technologies: We are still in an investment blitz for artificial intelligence and green technology. Major private and government investment in these areas over the coming years will require higher rates to stop the economy from overheating.

• Deglobalisation: In a famous 2005 speech, then soon-to-be chair of the Federal Reserve Ben Bernanke observed that the growing US current account deficit was evidence of a “global savings glut”, in which emerging economies with high savings rates were buying US Treasuries and assets — for lack of better investment opportunities in their economies or elsewhere. This flowed through to more available credit and higher savings in the US economy, meaning the neutral rate remained low despite high short-term rates, pumped up asset prices, and low Treasury yields (referred to by Alan Greenspan, Bernanke’s predecessor at the Fed, as “the conundrum”).

  But we are now in a period of deglobalisation and waning global growth. Global slowdowns and increasing tensions between the US and China will stymie flows into US assets, and US savings will not be as robust as a result. As evidence, foreign holdings of US Treasuries have decreased as a percentage of US GDP in the past few years.

  The US economy has also been reliant on cheap goods and services from China and emerging markets. If the US becomes more protectionist going forward — potentially through Donald Trump’s proposed tariffs, a crackdown on Chinese overcapacity, or a war in Taiwan — prices could go up, and the neutral rate would have to be higher.

The market seems to have bought into this argument, too. Long-term Treasury yields, which are a reflection of long-term inflationary expectations, have trended up since the pandemic:

But all of these arguments have potential faults. To address them one by one:

• Recent experience: This cycle has been weird. Government stimulus and pent-up savings from a once-in-a-century pandemic collided with supply shocks from an unexpected land war in Europe. To extend our “one month is just one month” phrase, “one cycle is just one cycle”.

• New technologies: The long-term outcome to the AI investment craze would theoretically be higher productivity, which could translate to higher savings, if more productive companies are able to harvest higher earnings and then pass those on to their employees and investors. And investment could be lower in the long-run if AI raises the marginal productivity gains from investment, meaning that businesses will need to invest less to earn more.

• Deglobalisation: While the global savings glut might be waning, the US economy and market have still outperformed their developed and emerging counterparts. The market remains liquid, US asset prices continue to rise beyond expectations, and there is still outsized global demand for US Treasuries and equities. In other words, capital is still straining to get to the US.

  We also don’t fully know the direction of travel of the US-China relationship. If Beijing is able to release cheaper green technologies and electric vehicles without clashing with western nations, or if tariffs are implemented that equalise the prices of these technologies, rather than penalising Chinese goods, we could keep the inflationary outlook anchored.

In a blog post last week, Massachusetts Institute of Technology economist Ricardo Caballero made another interesting point. He observed that sovereign indebtedness has increased around the world, and that trend is likely to reverse in the US and other countries as governments face pushback on ballooning deficits, either from voters or the market. If governments have to claw back their spending and stimulus, they may need to lower rates in the longer-term to stoke domestic demand.

Demographics are also a confusing piece of the puzzle. Generally, the economic logic — promoted by economists such as Charles Goodhart — is that as a population gets older, r* will go up for two reasons. First, young labour will be in shorter supply, so wage competition will drive up inflation. And second, a higher proportion of the population will be spending down their nest eggs and pensions, resulting in investment outpacing savings.

But to some economists, that argument is for an “aged” population, or one that has reached a critical mass of elderly people relative to young workers. Leading up to that point, populations are “ageing,” which drives r* lower. As more people gear up for retirement, savings rates go up, especially as people fret over waning pensions. And before the demographics shift too heavily towards older people, many of the elderly may choose not to spend down their savings, and instead pass them down to their children. Japan is a useful example here: it had negative rates for eight years, but just this past year it raised rates, in part because competition for wages led to inflationary pressures.

It’s hard to say where the US is on the “ageing” to “aged” spectrum, making it difficult to draw conclusions about r*. A recent influx of immigration appears to have helped the broader demographic outlook. But, earlier this year, the Congressional Budget Office reduced its fertility estimates, suggesting the US will transition to “aged” sooner rather than later — if it is not already there.

r* may indeed be higher, as the central bank and the market have suggested. But our point here is there is not a consensus among the Fed or economists, and a lot of counterarguments to take into consideration. Bernanke would often refer to the Fed’s efforts as “learning as we go”; After this strange cycle, and with complex political, demographic, and technological shifts on the horizon, the Fed and investors should keep that learning mindset.

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