A lot of times — too often — we take what ostensibly smart people have to say at face value, particularly when the topic’s esoteric. And no topic’s more esoteric than the neutral rate.
Last week, while making the case for a sharply lower Fed funds rate, Scott Bessent told state television he wasn’t trying to “tell the Fed what to do” when he suggested cutting rates by 150bps recently. “What I said was that to get to a neutral rate on interest, that would be an approximately 150bps cut. I did not call for them to get there.”
That sounds reasonable enough, assuming you put any stock in the neutral rate as a concept, but does it hold up to scrutiny? Yes and no. The figure below shows three Fed models of the neutral rate.
In order to get nominal neutral, you add 2% (the inflation target) to a given model’s current (which in this case generally means Q1) estimate of the real neutral rate. On that score, the Fed’s only meaningfully restrictive on the HLW model, which is the most famous.
As JonesTradings’ Mike O’Rourke pointed out, “the problem is that core PCE inflation is not at 2%, it is at 2.8, and based on the CPI and PPI reports, it will not be moving lower at month-end.”
When you impute nominal neutral using current core PCE, you come away with Fed funds below the neutral rate implied by the Fed’s DSGE model and the Lubik-Matthes mode. Even the HLW model suggests room for just three cuts, which Jones gently noted “is vastly different than asserting models indicate the neutral rate is 150bps lower.
Bessent, in the same cited interview, told Maria Bartiromo that, “if one believes in the neutral rate — a model is approximately 150bps lower.”
But, again, that’s only the case on one model estimate out of three, and only if core PCE’s running 2% which, Jones dryly remarked, is “a level it has not seen in more than four years.”
Is tariff inflation one off and transitory, any more so than Covid. Maybe Covid lasted some years, but the impact is mostly done. It manifested as a supply chain shock (and consumption shock for services) that gradually abated as people returned to work and normal social life. Rates were reduced and handouts were given to juice consumption. Tariffs feel like a repeat; a supply chain shock that grows into a consumption shock. Like Covid, the strategy is reduce rates and handout stimulus except the stimulus math stinks for the middle class; $4k inflation cost minus $1k stimulus equals $3k poorer. What is more worrying is tariffs as planned are not transitory. These are fixed costs that don’t expire, can go up at any time and are unamenable to productivity gains. Other countries don’t pay, they just get pissed. Companies won’t eat the costs regardless of what they say now to avoid retribution. They didn’t do it for Covid which killed tens of millions so they won’t do it now. I can’t figure out how this could possibly end well for anyone.
The US is a money vampire that has stuck its fangs into the global femoral vein and thinks it can keep sucking forever. When do US consumers finally see the Ponzi scheme. They have to pick up the tab for decades of profligate government spending, even as their government tells them otherwise. However, the truth will be their savings accounts. Will Q1 26 be the time to start looking for those roosting chickens.
I like the reference to “state television”. Can’t recall if you used that before.
Why let reality get in the way of a good model. The Clown administration doesn’t live in the real world so why bother with real data.