Wishing upon an r* - What is the neutral rate?

 

The neutral rate of interest r* has been a critical conceptual guiding light for the Fed. While inflation policy is to reach the target 2%, the rate policy if you could day there is one is to reach r*. Yet, r* is calculated rate not a market rate. 

The neutral rate is a simple concept, the rate that will stabilize the utilization rate of the economy or allow for zero output gap. It is based on set of assumptions including the Philips Curve, the natural rate of unemployment, the output gap, and the economic utilization rate. The general view is that r* has fallen and is hovering around zero, so the nominal neutral rate should be just over 2% if we are at the inflation target. In the post-GFC era with a zero bound, it was viewed that QE was necessary because nominal rates were too restrictive. 

However, there has been some discussion about r* now being higher than the last decade. A structural change in the fundamentals that would create an environment where r* is higher would be a sea change for market thinking and would mean that we will not see the low rates for the decade before the pandemic. A higher r* will allow or force central banks to push rates higher with less concern that they are being too restrictive. For example, if we use the current PCE we are at a positive real Fed funds rate, but we may still be at a loose level given a higher r*. 

So what is different today? The neutral policy rate does not have to be as low given stronger fiscal policy, stronger corporate balance sheets, excess household savings, and better household balance sheets, On the flip side, a slower global growth rate and a tightening of credit may require a low neutral rates to balance utilization. 

Discussion of Fed policy must be more inclusive than just saying that inflation must get back to 2% and the Fed wants to avoid a hard landing. The rates necessary to get to the dual objective must be considered and should be on the minds of investors.