MNI ANALYSIS: Fed Considers If R-Star May Be Headed Higher

--Fed Governors Flag Upside Risks for Natural Interest Rate

--Safety Premium of Treasuries May Be in Decline, New York Fed Economist Says

By Jean Yung

     WASHINGTON (MNI) - A new debate has emerged inside the Federal Reserve over

whether the natural rate of interest, or r-star, is rising as global growth

picks up steam and stimulative fiscal policies juice a U.S. economy already

close to full employment. 

     For years, Fed officials have revised downward their estimate of the level

at which rates might settle over the long run, due to sluggish growth and other

structural factors. But as economic headwinds shift to tailwinds, some

policymakers are raising the possibility that r-star may be headed significantly

higher, widening the scope for the Fed to raise rates to remove policy

accommodation. 

     Fed Governor Randy Quarles on Feb. 26 laid out an optimistic assessment of

the current economic outlook, noting there's a "real possibility" that certain

factors could shift the economy onto a higher growth trajectory, a point since

repeated by Chairman Jay Powell and Governor Lael Brainard.  

     Higher growth potential "could mean a higher natural interest rate, which

would increase the amount of accommodation provided at a given level of the

Federal Reserve's policy interest rate," Quarles said. 

     --DECOMPOSING RISING R-STAR

     New York Fed Vice President Marco Del Negro, co-author of an influential

2017 study on the forces behind persistently low interest rates, agrees that

there appears to be evidence key trends influencing the natural rate are

changing. 

     "My guess is that r-star might have gone up quite a bit, especially in the

short run," compared to a year ago, he told MNI in an exclusive interview. "In

the long run, we seem to find that it has increased as well." 

     His paper estimates that the natural rate fell by half since the late 1990s

to roughly 1.25% in early 2017, and suggests a rise in investors' desire for

Treasuries due to their safety and liquidity features has been a key driver,

although sluggish growth also plays a role. 

     The rise in Treasuries' "convenience yield" explains up to 1 percentage

point of the decline in the real return on Treasuries over that period and is

precisely estimated, according to the paper. Slower economic growth accounts for

up to 60 basis points of the trend decline, but is subject to sizable

uncertainty.

     "We don't rule out that the decline in the growth rate has been important.

We just find that it is imprecisely estimated, so we're not quite sure how

important it has been," Del Negro said. "We claim to be quite sure about the

importance of the convenience yield."

     Part of an analysis Del Negro and his team are doing now is to decompose

the recent rise in r-star. "While growth prospects have increased, there is some

evidence that the convenience yield for U.S. Treasuries may have declined," he

said. 

     If the recent depreciation of the U.S. dollar signals that U.S. assets have

become less attractive to investors, that could translate into a fall in

Treasuries' convenience yield -- a reversal of the very trend in the late 1990s

and early 2000s that drove U.S. interest rates lower. 

     --R-STAR DOVES

     Economists have put forward other explanations for the secular decline in

real rates. 

     San Francisco Fed President John Williams, whose estimates of r-star does

not take into account the convenience yield, late last year forecast the

longer-run nominal fed funds rate at just 2.5%. As he sees the long-term trend

in GDP growth to be as low as 1.5%, it signals future interest rates could be

permanently lower.

     Williams has not recently updated his views on the topic, but St. Louis Fed

President James Bullard on Feb. 26 also reckoned "there is only modest evidence

that key trends influencing the natural rate of interest are changing today." 

     "This suggests the natural safe real rate of interest, and hence the Fed's

policy rate, can remain low over the forecast horizon," he noted. 

     They may be setting up for a debate over whether the long term outlook may

be looking up. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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