We may be living through the early stages of a “historically unique period.”

In the context of the unobservable neutral real Fed funds rate, it’d be the second such period in a row.

“Just as the post-GFC economic environment may have been a historically unique period that depressed r-star, the pandemic period could equally be a historically unique period that has temporarily lifted [it],” Deutsche Bank’s Matt Luzzetti and Matt Raskin wrote, taking a deeper look at what’s quickly becoming a hot topic in an environment of hot data.

I’ve spent quite a bit of time on this subject of late, and for good reason. If r-star is higher than policymakers believe, then policy itself may not be as restrictive as you’d be inclined to think after 450bps of rate hikes, if it’s restrictive at all. If there’s elegance in simplicity, that’s among the best explanations on offer for why the US economy doesn’t seem to be responding to ostensibly “forceful” Fed tightening.

The figure on the left below shows various estimates of r-star, and the average across those estimates.

To say this isn’t an exact science would be to understate the case. As Luzzetti and Raskin wrote, “the error bands often tend to be large enough that r-star may not be considered significantly different from zero” from the perspective of statistical analysis.

That said, it’d be some coincidence if every measure were moving up simultaneously and there was nothing to it other than statistical noise.

I’ve argued that this will eventually be too much for the Fed to ignore, particularly in light of persistently hot data and socioeconomic shifts which generally all point to a new epoch. Luzzetti and Raskin were quick to note that the Fed is in fact already paying attention: “Although it has not yet lifted the median implied estimate of r-star in the SEP, there was a small upward migration of at least three dots in December.”

Much has obviously been written about the factors that depressed r-star post-financial crisis, not least among them household deleveraging. But as Luzzetti and Raskin pointed out, fiscal policy — or, more aptly, the lack of fiscal initiative in the face of what some argue were misguided pretensions to austerity — probably played “an important role.” Contractionary fiscal policy post-GFC “acted as a drag on growth that supported lower interpretations of r-star,” they said.

Developed markets are at a crossroads with fiscal policy in 2023: The pandemic experience showed the public what’s possible, but the ensuing inflation was blamed in part on fiscal largesse. The future of fiscal policy in Western democracies is ultimately up to voters, and my assessment is that the American public’s pain threshold for austerity is now lower than it was pre-pandemic. In Europe, the legacy of the debt crisis means many voters have a visceral aversion to the mere mention of austerity.

Luzzetti and Raskin wrote that “unprecedented fiscal stimulus has no doubt contributed to the economy’s resilience and inflation’s persistence, which could, in turn, contribute to the rise in estimates of r-star,” but they also noted that if the infatuation with fiscal stimulus proves fleeting, and fiscal policy turns restrictive (e.g., as a result of the debt ceiling negotiations in the US), “the recent rise in r-star could prove illusory.”

The table above is notable for what’s not currently possible to project — three of the most important determinants are question marks.

Regardless of short-term ambiguity around US fiscal policy, the balance of evidence suggests r-star is biased higher. For example, Luzzetti and Raskin wrote that “if the US undertakes a stronger climate change agenda or endeavors to onshore more economic activity, it could lead to greater investment.” From a global perspective, Europe might be compelled to lift its defense spending going forward, for reasons I assume will be clear to readers. And China’s shift towards a consumer-driven economic model might lead to less savings across the world’s second-largest economy.

And there’s more. “US dollar denominated debt could suffer from less favorable supply/demand dynamics, with an ever-rising debt load increasing supply while global investors may have more appealing opportunities abroad as bond markets shrug off negative rates and Japan rolls back its extreme monetary accommodation,” Luzzetti and Raskin went on, noting that “the potential for some economies to shift their reserves away from US debt at the margin could add to this.”

What does it all mean? Well, the implications of a higher r-star are “profound,” as Deutsche Bank put it. Higher expected short-term rates would shift the entire curve up, and the read-through for policy (higher r-star means current policy isn’t as restrictive as it would be if r-star were lower) suggests the situation would be compounded by expectations of additional rate hikes.

Beyond that, term premia would rise. R-star isn’t observable, and estimating it is the furthest thing from straightforward, which means even if there’s broad agreement that it’s higher, there will nevertheless be considerable uncertainly about its location. In addition, the further away from the lower-bound policy rates are, the more countercyclical breathing room the Fed will have when monetary policy needs to ease. That means the odds of reaching the lower-bound would be reduced, thereby lowering the chances of policymakers falling back on large-scale asset purchases during future periods of easing. Less QE would remove a key factor holding down term premia.

Of course, the answers to the myriad questions posed above won’t reveal themselves for quite a while, but whatever the answers are, they’ll define the contours of the macro-policy nexus going forward.

As Luzzetti and Raskin put it, this will likely “become a key market theme ahead, either because the economy remains resilient and questions around the restrictive level of the Fed funds rate intensify, or, as it becomes clear the Fed has held policy at a sufficiently restrictive level and begins to ease, focus inevitably turns to what level of rates is the new normal in the post-COVID world.”

Related:

Finding The North Star In Oz

Upon A Star+