What If the Neutral Interest Rate is Higher Than We Think?

First, the semi brighter side. Reuters recently surveyed 108 economists to see what they thought would happen with inflation and interest rates.

Of the nearly two-thirds of economists surveyed in May 7-13, 70 of 108, predicted the first reduction in the fed funds rate in September, to a 5.00%-5.25% range. Those results compared with just over half expecting a September cut when they were surveyed last month. Only 11 forecast a July cut and none said June, compared to 26 and four in the April survey.

September as the earliest/? Yes, it makes sense with economic data as it has come in. During the press conference after the May 1 meeting of the Federal Open Market Committee, the part of the Federal Reserve that sets baseline interest rates, Chair Jerome Powell made a couple of statements that almost guaranteed September as being the earliest they might lower rates. He mentioned that the FOMC had been feeling more confidence and didn’t want to change directions on a month or two of data, but that there had now been a solid quarter where inflation was getting hotter, which reduced their confidence on how things were proceeding.

A GlobeSt.com analysis said that if it took a full quarter to redugce confidence, it would seem likely at least another quarter of data would be necessary to change sentiment again. Q2 data won’t be fully in until July. Assuming things don’t suddenly readjust themselves by then to be clearly where they were in December, that would make August still seem early, leaving September as the first likely time for a decrease.

“For the Fed to cut rates, we have to see a change in trend,” Chris Low, chief economist at FHN Financial, told Reuters during its survey. “One month of good news will not be enough to allow a cut, they need several months. There is a pretty significant risk they will do less than two.”

And that gets to the question of whether the so-called neutral rate is higher than what many think.

“We’ve long held that the neutral rate of interest—the theoretical rate that neither stimulates nor restricts an economy—is higher than many may believe,” Roger Aliaga-Diaz, Vanguard global head of portfolio construction, said in an emailed note in late April. “The ultra-low interest rates of the pre-COVID era are history.”

As Reuters noted, the return of inflation means ultra-low rates are history. “And markets now reflect a scenario where even the neutral interest rate that balances the economy in the long run after factoring in inflation, dubbed ‘R-star’, is rising, economists say.”

However, there’s a lot of disagreement over what the neutral rate currently is, and even how to calculate it.

There are five factors Reuters pointed to:

1. High government borrowing for climate and military spending will drive up the need to sell Treasury debt. Extra supply could drive down demand, lowering prices and, as a result, pushing up interest rates.
2. The ratio of older people to younger continues to rise, forcing rates up as a pre-retirement savings glut means more people have less need to borrow, so government bond prices drop, and yields go up.
3. Climate change is demanding large amounts of spending. There’s major debate on what they could mean for the neutral rate.
4. Generative artificial intelligence could boost economic growth and ultimately put upward pressure on rates.
5. Changes in supply chains since the pandemic, bringing more manufacturing to the Americas and Europe. The regions have higher manufacturing costs and could be inflationary.

A new normal could revive earlier periods where much higher interest rates were common.