If the Fed’s searching for clues about what drives shifts in the market’s perception of the neutral rate, policymakers might consider looking in the mirror.
That was one message from an expansive new Goldman note penned by Dominic Wilson and Vickie Chang.
The neutral rate is a hot topic in 2023. The r-star discussion elbowed its way onto center stage following the pandemic amid what many view as epochal macro, geopolitical and socioeconomic shifts. This week, markets were on edge about the prospect of an upward shift in the median Fed official’s estimate of nominal neutral or, colloquially, a higher long run dot in the projections accompanying the September FOMC meeting.
The argument, in essence, is that the equilibrium rate is now higher, at least for the US economy. If you want to explain why the economy continues to outperform in the face of the most aggressive rate-hiking cycle since the Fed was chaired by an NBA small forward, Occam’s razor suggests policy isn’t actually restrictive, or if it is, only recently and not by much.
The figure, from Goldman, shows a marked upward shift in neutral rate proxies since early last year.
“There are unquestionably those in the market who continue to think r-star is higher, post-pandemic inflation has structurally moved up, and the Fed needs to increase its inflation target,” BMO’s Ian Lyngen and Ben Jeffery remarked. “Regardless of whether such rationale is accurate, the reality is that so much Fed credibility is contingent on holding the 2% objective and remaining restrictive long enough to achieve it that we struggle to see any reason for the Fed to waver.”
After referencing the chart shown above in noting that measures of longer-dated real rates have reversed sharply higher over the last year and a half, Goldman’s Wilson and Chang analyzed the history of the estimated spot real yield 10 years forward. “What is striking is that measures of longer-term instantaneous US rates appear to have been characterized less by a continuous process and more by ‘regimes,'” they wrote.
As it turns out, it wasn’t macro events which defined the regimes. It was policy. Monetary policy.
“The main shifts lower occurred in August 2011 and in 2019,” Wilson and Chang said. “Only since mid-2022 has the market durably pushed longer-term rates back into a higher regime, with a further step to the pre-2011 regime identified by the latest move up in rates in August of this year.”
Those shifts, they went on, don’t “map well to key information about savings/investment balances or many of the main drivers of structural views of neutral rates.” Rather, what seems to matter are “shifts in the policy rate environment itself that made the distributions of the prior regime untenable.”
They went into considerable detail. To wit:
In August 2011, the Fed introduced calendar-based forward guidance, promising to keep rates at the zero lower bound for at least two more years (so close to five years cumulatively). This occurred at a time when the US economy stumbled again, and large fiscal restraint was baked into the resolution of the debt ceiling crisis. At that point, the market may have decided that, with the funds rate set to spend a multi-year period at the bottom end of the previous cycle’s prior 0-6% range, it needed to lower its expectations about the distribution of rates further along the curve. In late 2018, the realization that the Fed hiking cycle had peaked at a 2.5% rate — a move confirmed by Fed rate cuts starting in July 2019 — made it hard to price the long-term rate meaningfully above that level. In 2022, the acceleration of the Fed hiking cycle to a 50bps pace in May 2022 and 75bps pace in June 2022 made it far easier to envisage policy rates exceeding the 2018 peak (and more recently the peaks of the 2004-06 cycle) than when policy rate changes were seen to be capped at 25bps increments. And now, an economy that appears to be avoiding recession with a funds rate firmly above 5% has made it easier for markets to entertain that rates could more persistently stay close to current levels. Even the attempt to revert to the pre-2011 regime in 2013/2014 was clearly related to the perceived shift in the Fed’s policy stance amid the taper tantrum and hopes of an earlier exit from zero rates.
The upshot: What counts is incoming (i.e., “new”) information about boundaries for the policy rate, not actual economic shifts.
That isn’t a new observation. But Wilson and Chang cast doubt on one common explanation for the phenomenon: The idea that the Fed has special insight into the neutral rate that’s only revealed to the market through policy decisions. Jerome Powell would scoff at that idea. He’s highly skeptical of the Fed’s capacity to estimate neutral, and Goldman is too.
“The most obvious explanation for the shifts in longer-term rate pricing since 2022 is simply that realized policy outcomes made the prior pricing untenable,” Wilson and Chang pressed, before driving the point home as follows:
The market understands that Fed policy generally spends time in a relatively narrow range during stable expansions; falls sharply in recessions and then rises again in recoveries. It has an assumed range for the funds rate in mind, based in part on realized historic ranges, alongside the Fed’s communications and the current cyclical state. Only when that distribution is fundamentally challenged has it generally attempted to adjust its views.
What does this mean currently? Well, that depends on your definition of “currently.” One commonly cited explanation for last month’s move higher in long-end US yields was the notion that the market was again reassessing the neutral rate. That’d be the context for any upward shift in the long run dot over the next several FOMC meetings. In Jackson Hole, Powell suggested the Fed isn’t ready to weigh in definitively on r-star, which in turn means the long run dot is very unlikely to move sharply higher. A small bump would surely be a market-moving event, but it’d take a 75bps shift (at least) to close the gap with some market-based measures. That isn’t going to happen in the near-term.
If by “currently” you mean in the context of the cycle and what comes next, Wilson and Chang reiterated that too many investors seem wedded to a structural view of the neutral rate which is biased heavily by the post-GFC experience.
“An extended private sector deleveraging cycle alongside public sector austerity is a very different environment from one with strong private sector balance sheets and persistently supportive fiscal policy,” they cautioned, tying it all together. “Capturing those differences adequately in a structural model of the neutral rate is hard, so what realized policy tells us about the likely funds rate range may prove at least as good an anchor.”
I knew Bernanke competed in the National Spelling Bee, but had no idea he had b-ball skills.