Former Fed Vice Chair: Neutral Interest Rate Unlikely to Rise Significantly

Clarida believes that in this round of the Federal Reserve's interest rate cuts, the neutral interest rate will only rise moderately, and a more significant change will be the steepening of the bond yield curve.

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

After the Federal Reserve's first interest rate cut, the market's topic of discussion has shifted from "when" to start cutting interest rates to the "direction" of interest rates.

This shift is not just a semantic issue. The ultimate level of interest rates is important for the entire economy. However, the discussion often too narrowly focuses on the neutral real Federal Reserve policy interest rate, namely R-star (hereinafter referred to as the neutral interest rate). This refers to the interest rate that neither stimulates nor inhibits economic growth.

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The neutral interest rate implies an "Goldilocks" interest rate range that allows the economy to maintain price stability and maximize employment. Although the neutral interest rate is crucial for understanding how monetary policy will evolve in the coming years, its estimation is not precise. It cannot be observed and changes over time, driven by domestic and global forces in the United States.

Looking back at 2018, inflation reached the target of 2%, and the economy was booming with full employment. That year, the Federal Reserve raised the federal funds policy interest rate to 2.5%, which translated into a 0.5% real interest rate, seen by many as the "new" neutral level of monetary policy.

In contrast, before the global financial crisis, the neutral interest rate averaged around 2%, with the federal funds rate hovering around 4%. Fast forward to today, the Federal Reserve's dot plot (policymakers' interest rate forecasts) indicates that once inflation stabilizes at 2% and the labor market is in a state of full employment, the target for the federal funds rate will be around 3%.

I agree that the neutral interest rate may be adjusted up from the pre-pandemic 0.5%, but I believe this adjustment will be moderate. Others believe that the neutral interest rate may need to be far higher than the Federal Reserve's forecast and the financial market's pricing of about 1% (that is, 3% minus 2%).

They point out that the factors that kept interest rates low before the pandemic have reversed, and the fiscal outlook for the United States is worrying, with rising deficits and debt. The United States may also be on the verge of an artificial intelligence-driven productivity boom, which could increase the demand for loans to U.S. businesses.

So, where is the true neutral interest rate? Of course, the U.S. Treasury and private sector borrowers issue bonds along a complete yield curve, and historically, the slope of this yield curve has been positive——interest rates rise over time to compensate investors for the risk of holding debt for a longer period. This is known as the term premium.The inversion of the U.S. bond yield curve following the Federal Reserve's aggressive interest rate hikes is rare, but it is not the new normal. As the Federal Reserve lowers rates, reducing "front-end" interest rates, the yield curve will adjust over the next few years, becoming steeper relative to pre-pandemic levels, thereby balancing the demand and supply of U.S. fixed-income products. This is because bond investors will demand higher term premiums to absorb the surge in bond issuance.

Just like the neutral interest rate itself, term premiums are unobservable and must be inferred from noisy macroeconomic and market data. There are two methods to do this.

The first method is to estimate the expected average of the federal funds rate over the next 10 years through surveys of market participants and compare this estimate with the actual yield of the 10-year U.S. Treasury note. According to recent surveys, the implied term premium estimate derived from this method is 0.85 percentage points.

The second method is to use statistical models of the yield curve, which currently estimate the term premium to be approximately zero. Personally, I prefer to rely on the method based on surveys of market participants and believe that the current term premium is positive and may continue to rise.

Given that the market must absorb a large and growing supply of bonds in the coming years, interest rates may be higher than in the years before the pandemic. However, I believe that most of the necessary adjustments will be reflected in a steeper yield curve, rather than a significant increase from the federal funds rate itself.

If my view is correct, this is a good sign for fixed-income investors. They will be rewarded for taking on interest rate risk during economic booms, and they will also benefit from the hedging value of bonds in their portfolios during economic downturns. At that time, there will be greater scope for interest rates to decline, leading to higher bond prices.