Evening Brief – 08.23.23

Star Light, Star Bright 

There has been a flutter of discussion on Wall Street over the past few days centered around the topic of the Federal Reserve’s “neutral rate” or “R-star” (r*) moving higher.  

R-star is the long-run real neutral rate of interest that balances the economy. When the economy is at full employment, the real interest rate is neither expansionary nor contractionary.  Economists use the r* to assess interest rate policy. According to the hypothesis, a neutral rate neither fuels nor restricts growth and inflation.  

The huge supply-side distortions of the COVID-19 pandemic and last year’s energy shock have obscured where that r* lies. However, as normalcy approaches, the New York Fed has provided its estimate of where it should “shine.” 

Katie Baker, Logan Casey, Marco Del Negro, Aidan Gleich, and Ramya Nallamotu noted some of the reasons why their estimate of the short-run natural rate of interest (in inflation-adjusted terms) increased from 0.81% in December 2022 to a mouth-opening 3.57% in March 2023 in a recent post on Liberty Street Economics.  

According to their most recent model results, r* will fall to 2.22% at the end of 2023, 1.77% at the end of 2024, and 1.47% at the end of 2025 – all remaining at levels that fuel the debate about raising the r*. 

“The model rationalizes these developments by postulating that the short-run natural rate of interest has increased considerably over the past year. This, in turn, has implications for the speed of the decline of inflation toward the FOMC’s long run goal and for assessing the stance of monetary policy,” noted the economists. 

The researchers’ higher neutral rate stands in stark contrast to the Fed’s own estimates. To achieve a real neutral rate of 50 basis points, the central bank assumes a real longer-run inflation projection of 2% and a policy rate of 2.5%. 

The results also imply that, should the neutral rate remain elevated, the Fed will have a difficult time lowering interest rates as the market generally anticipates for next year. 

While the actual level of r* is a matter of debate, market participants are uncertain as to the Federal Reserve’s current view on the “natural” rate of interest. Wall Street is hoping Chair Jay Powell will address it at the Kansas City Fed’s Jackson Hole symposium on Friday. 

Real bond yields on longer maturities have soared to their highest level since 2009 despite stable market forecasts for inflation and Fed interest rates. This could be an indication from investors that r* may eventually be higher; however, it is unclear by how much and when. 

Powell may not be able to offer much clarity, except for the fact that the level of r* is unquestionably highly ambiguous but a discussion about it is now becoming increasingly likely.