Is the Era of Ultra-Low Interest Rates by the Fed Over?

In a significant move that resonated across financial markets, the Federal Reserve announced a rate cut on Wednesday, signaling a cautious pause in further reductionsFed Chair Jerome Powell emphasized that the Federal Reserve is now much closer to what is considered a neutral interest rateThis poses an intriguing question: just how far is the United States from this elusive neutral rate? This inquiry represents a key issue that will shape the Federal Reserve’s future policy decisions.

The concept of neutral interest rate has gained newfound importance in the post-pandemic economic landscapeThe neutral rate, often described as a level of interest that fosters maximum employment and stable prices, cannot be directly observed or measured; rather, it is inferred from the state of the economyWhen borrowing and spending are robust, it may be that current interest rates fall below this neutral threshold, generating upward pressure on prices

Conversely, when borrowing and spending lag, and inflation diminishes, interest rates might exceed the neutral rate.

The debate surrounding the neutral rate earlier this year lacked urgency, primarily because most Fed officials concurred that interest rates were excessively restrictiveHowever, the landscape has transformed, as the Fed has now lowered rates by a full percentage point and signs of economic vigor have emergedThis change echoes sentiments in the financial corridors, akin to a ship’s captain meticulously steering away from the dock’s edge as the vessel approaches the ramp.

Powell noted on Wednesday, “We do not know precisely where it stands, but… we can be sure that we are now closer by about 100 basis points… From this point forward, we are entering a new phase in which we will be cautious regarding future rate cuts.” This highlights a subtle shift in tone and strategy from the central bank, aiming to balance growth while maintaining price stability.

An intriguing facet of this discussion is the notion that the neutral rate may now be considerably higher than it was before the pandemic

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Following the 2008 financial crisis, economists and Fed policymakers continuously revised downward their estimates of the neutral rateThis decline persisted despite years of ultra-low interest rates and monetary stimulus that failed to ignite significant economic recoverySome analysts posited that the combination of demographic headwinds stemming from an aging workforce and persistent insufficient investment demand would keep rates low for the foreseeable future.

However, post-pandemic, the financial landscape shifted once again, with various fiscal stimulus measures stabilizing the economy at a new equilibrium which seems to have fostered a recovery of the neutral rateThroughout the past year, estimates among Fed officials have consistently increased.

The Federal Reserve’s quarterly forecasts for long-term interest rates effectively serve as their estimates for the neutral rate

Notably, the median predictions plunged from 4.25% in 2012 to 2.5% by 2019, where it remained until 2023. This year, however, projections for neutral rates rose steadily throughout all four quartersThe latest update released on Wednesday indicates a neutral rate of 3%, with 8 out of 19 officials estimating it above that threshold, whereas only two officials were advocating for a neutral rate higher than 3% as recently as June 2023. The current benchmark federal funds rate stands around 4.3% following the recent reduction.

Should it be confirmed that the neutral rate has indeed increased, it may imply that the Fed will abstain from further rate cuts for an extended periodPowell expressed skepticism about relying solely on precise neutral rate estimates to guide policy, suggesting that the central bank can only gauge this metric by observing its effects on the economyHis former senior advisor, Jon Foster, has pointed out that this could lead to a scenario where, even if the neutral rate shifts upwards, the Fed might lack timely evidence to recalibrate its policies accordingly, estimating the neutral rate to fall between 2.5% and 4%.

Prior to making the latest cut, some Fed officials voiced hesitations about proceeding with reductions based on a potentially inaccurate understanding of the neutral rate

Dallas Fed President Lorie Logan cautioned that excessive rate cuts could lead to a resurgence in inflation, forcing the Fed to hike rates once moreShe emphasized that recent data may suggest the neutral rate has risen and is nearing the current federal funds rate level.

Moreover, the economy appears to remain robust despite increasing interest rates, which may be attributed to transient factors such as heightened immigration or the locking in of low rates during the pandemic by both businesses and householdsNevertheless, given sustained economic growth, policymakers might begin to consider that the economy has settled into a new normal where neutral rates are structurally elevated.

Jason Thomas, chief economist at private equity firm Carlyle Group, suggests that improvements in labor productivity could indicate that the economy is now on a different trajectory compared to the landscape observed in the decade following the global financial crisis