MNI: Fed Reluctant To Mark Neutral Rate Lower - Ex-Officials

The Federal Reserve will likely resist downgrading its longer-run assessment of neutral interest rates for some time, instead opting to test how the economy fares during the next rate-hiking cycle before it alters its view, former Fed officials told MNI.

The release on Wednesday of the Fed's SEP projections, which will extend through 2024, will probably continue to show a median expectation among FOMC members for longer-run rates of 2.5%, even though markets have been pricing in a terminal rate a full percentage point lower, the former officials noted.

"Rates in the long run are in the ballpark of 1.5% and could even be as low as 1%," said Nathan Sheets, former international finance division director at the Fed Board. "In that context, the 2.5% that the Fed has looks quite hawkish relative to those kinds of expectations. For that to come down, though, is a pretty heavy lift."

TESTING CYCLE

"The Fed's presumption is that the real rate should be positive, and a strong presumption that there's no reason for it to be negative," he said. "Could the Fed's long-run interest rate estimates go down to 2.25%? Yeah. But 2% is a stretch, and less than that is going to be a big stretch."

"If it comes, it is likely to be a several-year journey for them," Sheets said. "They want to see a cycle."

Jonathan Wright, a former member of the Fed Board's division of monetary affairs, agreed.

"Even if some of them are possibly thinking about r-star having gone slightly negative, which would mean a nominal neutral interest rate below 2%, I don't see the Fed writing that in this SEP or anytime very soon, even though that's something that is actually on the table," he said. "The Fed is very reluctant to fully embrace some of the research that points to r-star at zero or negative."

Amid the backdrop of steady long-run interest rate projections at 2.5%, that suggests the FOMC's 2024 forecasts would show quarterly rate hikes, they said. Additionally, as the hiking cycle starts and rates approach estimates of "neutral," the ex-officials said r-star would go from appearing as a guide to policy to something less definite on which participants would disagree.

PRODUCTIVITY UPTICK

"In reality, what they're doing in implementing policy is feeling out what the neutral rate is, in my opinion," said former Atlanta Fed President Dennis Lockhart. "There's probably a number in mind, but it could differ from committee member to member. The Committee will raise rates until they get indications in the data that they're approaching neutral rate territory."

Approaching the neutral rate would be reflected in healthy term premiums in the longer rates, healthy risk premiums, and in markets that are operating efficiently, perhaps without undue volatility, he said. Neutral rate territory would also come with quite modest progress in terms of employment and a static environment with inflation at or around target, he added.

While many of the ex-officials expected a fall in r-star, others held out the possibility that it could rise. "If I were betting on a coin flip, I would bet more likely down than up," said former Fed Vice Chair Alan Blinder. "The truth is that it had been on a downward trend for quite a while now."

Blinder is "not so convinced" that neutral rates will fall 75 bps through the decade on investment, as some have suggested. "The productivity numbers are now creeping up almost every quarter," he said. "Rapidly rising productivity creates a good environment for investment. It's a little too early to declare victory on that front but recent numbers look pretty good."

Tara Sinclair, a former visiting economist at the St. Louis Fed, said the economy could see significant investment in productivity-enhancing advancements.

"I'm quite optimistic that the terminal rate could actually climb a bit," she said.

ASYMMETRIC COSTS

Fed Chair Jerome Powell and Treasury Secretary Janet Yellen in recent months have both expressed optimism that neutral rates would rise, potentially providing additional space for policy makers in future crises.

Still, research by Fed economists has found that the costs of policy makers overestimating the natural rate are greater than the cost of underestimating it. "This finding might lead policymakers to err on the side of choosing a lower estimate of r-star or, equivalently, setting monetary policy as if they have embraced a lower r-star," the economists wrote in a blog published earlier this year.