Interest Rates May Not Be High Enough: Vanguard

The world of CRE finance has been caught up with discussions of when rate cuts should or will begin. In January, markets were excited by the prospect of an early cut. By early April, investors wondered if there would be the full three cuts they thought had been promised.

A couple of weeks later, the Federal Reserve leaned into backpedaling. Chair Jerome Powell said that “recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence.”

Recently, investment giant Vanguard dusted off a research paper its Investment Strategy Group published in the summer of 2023 that questioned whether the Fed or anyone else realized a basic economic assumption might have been wrong. Whether they were assuming that the so-called neutral rate of interest, also called R-star or R* — on which many decisions rest — should be significantly higher than regulators and financial powerhouses think.

The concept of the neutral rate of interest goes back to the late 19th century. It is supposed to be the short-term interest rate when the country sees full employment and stable inflation. It has held strong among economists for that long.

The neutral rate of interest matters “because it affects how the Fed judges whether the interest rates it sets are stimulating or restraining the economy,” according to the Brookings Institution. “The Fed may temporarily set the benchmark federal funds rate, the rate at which banks borrow from each other overnight, above the neutral rate to cool the economy or below the neutral rate to stimulate it. The neutral rate is essentially a guidepost for monetary policy.”

The Fed estimated the neutral rate at 0.6% in 2023 Q2.

Now comes the problem: If the Vanguard economists and investment analysts are right in their re-examination, R-star has increased significantly.

“Using data from 1940 through 2022, we show that R-star has risen approximately 100 bps since the Great Recession, to 1.5% today,” the paper says. “We attribute this rise to changes in factors unrelated to long-run trend growth. In our econometric analysis, we explore potential effects from demographics and structural U.S. fiscal deficits and find suggestive evidence that deficits have contributed to the recent, notable rise in R-star.”

That 1.5% is a far cry from 0.6%. The authors said that, based on their analysis, the benchmark federal funds rate should have hit 6% in 2023, not the 5.25% to 5.50% range the Fed has been using, with the long-term rate being 3.5%, “both higher than assumptions used by either policymakers or reflected in the term structure.”

“The investment implications of a higher R-star are perhaps more significant,” they concluded. “Our analysis reveals that the rise of R-star began before the onset of COVID and reflects changes in secular drivers that are unlikely to quickly reverse. This strongly suggests that the ‘new normal’ era of secularly low rates is already over, and perhaps an era of ‘sound money’ … has begun.”