Powell Says Neutral Rate Doesn’t Matter Today. He’s Wrong
The r-star discussion, which is to say the debate about where interest rates should be set over the longer run in order to balance the economy at full employment and stable price growth, doesn't matter so much for Fed policy today.
So said Jerome Powell, who participated in an event hosted by Stanford on Wednesday.
I don't think I agree. I think the location of neutral matters quite a lot for policy today. And tomorrow. And next month. And next year. It matters all the time, precisely because
Great, succinct analysis. Reminds me of your work from a few years ago (referencing Kocic) about boom-bust, leverage and volatility cycles, tail risk, etc. Not much talk lately about leverage but I doubt that’s b/c no one is playing a version of LTCM 2.0 (or 3.0, etc.).
The “unknowable side effects and consequences” tend to appear when the Fed gets complacent. Powell brushing aside concerns about the neutral rate that defines “restrictive” and “easy” financial conditions qualifies as complacent, but who knows when/if it will have any market impact. Commodities are definitely catching a bid…
I believe Powell’s final quote is key. I believe he and the majority of the Fed are convinced that current rates are very restrictive for major segments of the economy and the majority of Americans, while the remaining segments and higher income folks are just fine and dandy, and generally untouched / unaffected by said rates, … and will disproportionally benefit and thrive even more in rate hike scenarios…thus the current conundrum… there were 10 dots for 3 cuts, 9 dots for two cuts…given recent movements of oil / gas prices, gold, silver, copper, crypto, world war, etc., it seems pretty hard to make a compelling case for any cuts in the foreseeable future if Mr. Powell is counting on inflation continuing to fall, given these circumstances … like Steve McGarrett used to say…”it doesn’t wash, Dano…”
US policy settings aren’t restrictive to the US economy (to the ‘have’ big tech, to be specific) yes, but they surely are restrictive to the global economy (i.e. the rest of the world). You can count the rest-of-world economies and businesses in the ‘have not’ category. Given the current state of the world, I can understand why Powell put the neutral rate so low on the list of things that actually matter. Scoff as you will, but Powell’s also infallibly earnest when it comes to the Have-Nots.
Sometimes we do forget that the global economy isn’t synonymous with the US economy. There are 192 other economies that look up to the US for policy direction. Sure, we should all be autonomous, but it’s simply not possible to break away from the US, which owns the currency of the world. So unless Powell wants to say f*ck you to the rest of the world, he has to take them into account too when determining whether US policy settings are restrictive or not. Whether that’s common sense or bullshit depends on who you ask. I believe it’s common sense. Even if it’s bullshit (a wise man said that it’s all bullshit). I’ll take Powell’s bullshit over Larry Summers’s bullshit everyday of the week. You can count Saturdays and Sundays too.
Over the years I was hired as an economic/financial expert to testify in court about monetary values in various legal matters. To do that required the calculation of various present values. To do this type of analysis one either needs to estimate how inflation might affect various future cash flows and use a nominal interest rate to value those flows or to eliminate these problematic numbers, estimate them without considering inflation and apply a basic real interest rate. I chose that approach because it eliminated all arguments about inflation which can’t be effectively forecast. The real rate I employed, and the one most consistent with history, was 2.5%. No opposing council ever questioned this number in more than 40 cases in which I testified.
Perhaps Powell’s responsibility in this context is to speak clearly and explicitly, as you did when honoring your oath.
Is it plausible that the neutral rate in the (AI-impacted?) future may be quite different from the neutral rate today? If so, hunting for the “long term” r-star could have less relevance to tactical decisions right now. In general, these comments seem consistent with FOMC being data-dependent not model-directed. The Fed’s experience with models during the pandemic may have been less than confidence-inspiring.
I think you are spot on about the Fed questioning the reliability of their models. Exhibit One being the impact of rates on housing supply. If you are right, that is refreshing.
But do you think that AI will meaningfully bring down inflation? This is America! Won’t the cost savings via staff “rationalization” be passed along to shareholders rather than consumers? The experience from the advent of the internet supports the notion that the impact will be patchy rather than widespread. Some goods (esp tech gear) prices fell, but service prices did not fall as much, if at all.
But what do I know?
I have a vague notion that it may depend on where the cost savings land in the income statement. If AI reduces COGS, that may have a different effect on pricing behavior than if AI reduces opex (R&D + SG&A). This is not something I’ve thought through though (yes, I typed that combination just because it looks funny).
Following up, here is my vague notion. Suppose your company is happily operating at the product price and volume that maximizes gross profit – yes, this is a classic micro-economic equilibrium hypothetical – and then along comes AI.
If AI reduces your unit COGS by say 1%, that may motivate you to test the elasticity of your end market by lowering price in hopes of higher volume and gross profit even higher than you’d get by simply pocketing the lower COGS.
If AI reduces your opex by say 5%, why would that motivate you to lower price? Your unit economics are the same, the price-COGS-elasticity-gross profit dynamics are unchanged, you’re already at maximal gross profit, so lowering price will just hurt operating profit.
Thanks JL. That’s the big unknown. The impact will probably differ from industry to industry, no? Companies with a monopoly/monopsony position will probably be inclined just to pocket the extra OP and use it to fund more buybacks. Companies in the unfortunate position of being in a more competitive sector may be forced to pass some of the benefit on to consumers if a competitor does so. We’re still in the first inning or pre-game warmups!
I think of most LLM AI applications as R&D and SG&A, but that may reflect my ignorance or lack of imagination. Anyway, right or wrong, that makes me skeptical that AI if successful will be broadly disinflationary.