MNI EXCLUSIVE: Neutral Rate to Remain Steady: Fed Economists

By Evan Ryser

     WASHINGTON (MNI) - A key long-term economic measure the Federal Reserve

uses to guide interest rate policy should remain steady despite growing

uncertainty over the world economy and global trade, Fed economists told MNI.

     The neutral real rate of interest, r-star, is the long-term theoretical

level at which interest rates would neither stimulate nor dampen the economy,

and economists stress that the variable cannot be measured directly, only

estimated with great uncertainty.

     "What you see now is probably what you'll see going forward," one of the

economists, Reuven Glick of the San Francisco Fed, said in an interview. "I

would question the extent to which you'd think r-star is going to fall more just

on what has happened in the last few years on trade policy. I don't think

[uncertainty] is any worse now than it was when the question was what is the Fed

going to do, what are fiscal authorities going to do, in 2007, 2008, and 2009."

     Market indicators of uncertainty including the Vix index, Glick noted,

remain below levels seen during the Asian Financial Crisis, the Dot Com Crash,

and the Global Financial Crisis, even while global economic policy uncertainty

has reached new highs, as noted by the Baker, Bloom and Davis index which

quantifies newspaper coverage of policy-related economic uncertainty.

     --LONG RUN TRENDS

     R-star has been in decline for decades, starting possibly in the 1980s but

certainly by the 1990s. Following the Global Financial Crisis estimates have

r-star falling by some 200 to 300 bps. Today these lie within a range from 0.5%

to 1.5%, with most centered between 0.5% to 1%. Demographics, productivity, and

the desire for safe assets and liquidity are key drivers of the rate.

     One estimate finds that r-star fell by 150 bps due to risk aversion and

global safe asset demand since the Global Financial Crisis. U.S. federal debt

held by foreign and international investors has increased by 75.7% from the

fourth quarter of 2009 to the first quarter of 2019, to $6.5 trillion from $3.7

trillion.

     Demographic and productivity trends are also factors. The civilian labor

force participation rate has fallen, and the median age of the American labor

force has increased to 42.2 in 2018, from 38.3 in 1996 and 34.8 in 1978.

     Productivity meanwhile has remained subdued, despite an uptick in the

second quarter to 2.3%. The average annual rate of productivity growth from 2007

to 2018 was 1.3%.

     --THE FED'S R-STAR

     While understanding r-star would usually serve as a useful signpost, Fed

leaders have pushed back on expectations noting r-star is not determinative but

suggestive for monetary policy.

     Chair Jay Powell on Friday used his speech in Jackson Hole to say r-star

cannot be "directly observed" but its location must be judged with an "element

of risk management to be able to use them as guides."

     "Risk management enters our decision making because of both the uncertainty

about the effects of recent developments and the uncertainty we face regarding

structural aspects of the economy, including the natural rate of unemployment

and the neutral rate of interest," Powell added.

     The FOMC's own short-run r-star, a distinct estimate issued quarterly in

the Summary of Economic Projections commonly known as the "dot plot," fell to a

new low in June, to 0.5% from 0.8%.

     The significant fall in r-star may demand more fundamental change in

monetary policy, Powell added, as interest rates will run, on average,

significantly closer to their effective lower bound.

     San Francisco Fed President Mary Daly on Wednesday said recent Fed models

place r-star at "roughly 0.5 or 0.6." While uncertainty and safe asset demand

can push down the whole U.S. yield curve, she said, this effect should only be

temporary.

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

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