MNI INTERVIEW: More FOMC Members Set To Raise R-Star-Rosengren

More Federal Reserve policymakers are likely to raise their view of the longer-run neutral interest rate in updated forecasts this week to around 2.75%, meaning the central bank would have a slower path of cuts in coming years to a higher level, former Boston Fed President Eric Rosengren told MNI.

"The fact that we're keeping a pretty constant unemployment rate at a time when interest rates are well above that 2.5% has to start making people think about whether the real interest rate has increased more than people have expected," he said. Rosengren said he would pencil in a number a little higher than the FOMC's current 2.5% for the longer-run neutral rate.

"If you believe in AI that's going to increase productivity, that would imply R-star being higher. If you thought the deficit was going to continue to be an issue, less fiscal restraint means R-star is going to be higher," he said. "There are reasons and recent evidence to believe that R-star would be higher."

FEWER CUTS

A higher neutral rate has a big impact on whether monetary policy is as tight as some people are assuming, he said. "If R-star is not that low, then policy is not as tight. That would be consistent with the fact that we haven't seen as much slowdown in the economy."

Fed policymakers have highlighted the ambiguity around R-star, particularly since COVID. There is a wide divergence of opinion in Richmond and New York Fed research. A Dallas Fed estimate of short-term R-star is negative. (See: MNI POLICY: Lively Debate At Fed Over Possible R-Star Rise)

"Higher R-star also means you don't need to cut as much and at the end of the cycle and you'll be at a higher nominal fed funds rate," Rosengren said. "If you assume the inflation target is still 2% but now the real rate is not 0.5%, it's 0.75%, or potentially even higher. That means you don't have to lower rates as much to be at a neutral rate."

Analysts at Goldman Sachs estimated earlier this summer the funds rate, currently at a 22-year high of 5.25-5.5%, will eventually stabilize closer to 3-3.25% than to the FOMC’s 2.5% median longer run dot. "I think it's becoming more plausible over time," Rosengren said about those estimates. "That would argue that the Fed is seriously underestimating what R-star is."

The ex-Boston Fed chief also surmised some FOMC members may be lowering their long-run unemployment rate estimate below 4%. "If the long run unemployment rate drifts down, it means that more of the members are thinking that they can get a soft landing without a very significant trade off with unemployment," he said. Rosengren said he wouldn't drop it below 4%.

PROBABLY DONE HIKING

Slow growth in the range of 1-2% after this quarter for the following year, a slight increase in the unemployment rate, and some progress on the inflation rate mean the Fed is likely done raising rates, he said.

"I would say the changes in risk are probably important," he said, referencing past rate hikes, a possible government shutdown, the UAW strikes, dwindling consumer savings, and still-to-be-felt credit impacts from the banking stresses this year.

Rosengren said he expected a mildly hawkish FOMC statement this week and for "plenty" of officials to pencil in one additional rate increase, possibly in November. "Personally, I don't think one more increase is likely to be necessary, given my baseline forecast that the economy is going to be pretty weak in the coming year."

The former Boston Fed chief also foresees greater reluctance to cut rates next year. In June, the Fed penciled in 100 basis points of cuts in 2024. "I'd be surprised if they came down that rapidly," he said.

The Fed will keep rates elevated until core inflation drops below 3%, he said. "I don't see that happening at the earliest until spring of next year," Rosengren said. "The first cut will be later than people are expecting. It'll be a fairly modest pace of reducing rates until it becomes clear that they really are on the path to 2%."