Where Is The Neutral Fed Funds Rate?

True Confessions:  We don’t know, and neither does anyone else, including Chairman Powell and the FOMC. 

What Is the Neutral Rate?

The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.

You won’t find the neutral rate quoted on your computer screen or in the financial section of the newspaper. The neutral rate is an “inferred” rate—that is, it is estimated based on various analyses and observations.  –  Robert Kaplan, Former Fed Official , Oct ’18

Interestingly, Kaplan qualifies the neutral rate as the short-term “real” interest rate.  We assume “real” is consistent with the convention economic definition, nominal minus inflation.  

Chairman Powell recently stated: 

That’s why Powell and other Fed officials have said in recent weeks that they want to raise rates “expeditiously,” to a level that neither boosts nor restrains the economy — what economists refer to as the “neutral” rate. Policymakers consider a neutral rate to be roughly 2.4 percent. But no one is certain what the neutral rate is at any particular time, especially in an economy that is evolving quickly.  – PBS News Hour 

It’s unlikely these “policymakers” consider a “neutral” 2.4 percent Fed Funds as a “real” rate.  If so, assuming inflation falls back to 5 percent in the near term, the real neutral rate as defined by Kaplan would be 7.4 percent, about 650 bps higher.      

If you haven’t noticed yet, folks, there is a lot of obfuscation in the economics profession.

Are We There Yet?

Where is the neutral rate?  Let’s go to the videotape chart.

This image has an empty alt attribute; its file name is real-fed-funds_may23.jpg

History tells us the economy has never entered a post-War recession with a negative real Fed Funds rate.  The April closing real rate was -8.0 percent, and now a bit higher with the FOMC’s recent 50 bps increase in the nominal rate. 

“This time may be different,” but that’s rarely, if ever, bankable. 

The Fed And Mount Whitney

I backpacked up Mount Whitney, a 14,505-foot beast and the highest mountain in the contiguous United States a few times as a kid.  Talk about altitude sickness!  

The markets already have altitude sickness, and the Fed is barely out of base camp!

We don’t believe the volatility spike this year is because markets have suddenly become more efficient, only discounting future rate hikes, for example, as many argue.  It’s much more complicated. 

New World Order? 

The change in monetary regime is a big part of the markets’ nauseousness, but much of the queasiness has more to do with the fact markets don’t know how and what to discount.  We have never been here before and the times they are a-changin’.

Stay frosty, folks.  

The real Fed Funds rate, which is basically the fed funds minus the inflation rate, is…negative. Prior to every recession in the last 50 years, it has been positive. So, we have a long way to go. – Richard Bernstein (4 minutes in)

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