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A likely rise in the U.S. neutral interest rate driven by productivity gains and trillions of dollars in fiscal stimulus will be insufficient to prevent the Federal Reserve from returning to zero nominal rates in the next downturn, Kathryn Holston, who worked with New York Fed President John Williams in this area, told MNI.
Being stuck near zero "is something that we are going to have to contend with in future crises, unless we see a meaningful rise in the natural rate of interest, which is not something that I am expecting at present in any significant way," she said. "Fiscal spending could lead to a higher natural rate," said Holston, who worked with Williams as a Fed research assistant.
The so-called neutral rate of interest, also known as r-star, has been stuck near zero since the pandemic. Lately Fed officials have moved to open discussions about tapering asset purchases and pencil in rate hikes in the next few years with stimulus underpinning the fastest growth in decades.
Fed officials have sounded optimistic that recent productivity gains that would lift the neutral rate could last longer, but r-star is also influenced by demographics, inequality, savings rates, and demand for safe assets. Some of those forces together may keep downward pressure on rates despite President Joe Biden's spending push, Holston said.
NEUTRAL RATE BOUNCE
"We have these longer term factors pushing the natural rate down," she said. "If something like fiscal stimulus is pushing it up, it's still unclear what the end result is going to be."
Fed officials have said for years that demographics and population aging are secular factors in low rates and have adjusted by revamping their operating framework to average inflation targeting. Mary Daly of the San Francisco Fed recently warned climate change could also drag neutral rates lower by increasing consumers' precautionary savings and by hurting productivity.
The FOMC's own short-run r-star, issued quarterly in the Summary of Economic Projections, fell to a new low in June 2019, to 0.5% from 0.8%, and has remained there since throughout the pandemic. That means including inflation the Fed would likely raise the fed funds rate only as high as 2.5% to get to neutral, unless the central bank needs to cut down inflation momentum or the neutral rate continues to increase.
Some Fed high-frequency estimates put r-star at a record low in 2020 near -0.5%, while forecasts generated by the New York Fed show the real natural rate of interest increasing to 0% by the end of 2021 before rising to about 0.6% by 2024.
QUESTION OF PERMANENCY
Williams told reporters last week in response to a question from MNI that "hopefully as the economy gets back closer to full employment and as we get through that really unusual stage of Covid, we can revisit the model estimates" of r-star in a "few more quarters." Speaking months before Covid hit the U.S., Williams said he expected r-star to continue to move lower on demographic trends.
The NY Fed's estimates "end up with very similar results as ours, starting from a different model," said Holston, who is now an economist with the World Bank.
"Whether it's productivity changes, whether it's fiscal policy, in a longer term sense, it's going to depend on how permanent these changes are," she said.