Where is the Fed interest rate going?

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Where is the Fed interest rate going?

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Financial markets have capitulated to their expectations that U.S. interest rates will fall this year. At the beginning of January, they expected at least six quarter-point reductions by the end of 2024. Today, they are only sure of one. Traders are even betting that the next move could be upward.

Borrowing costs at the end of 2024 are therefore very uncertain. Do we know more about the direction that interest rates will ultimately take in the United States and elsewhere?

Economists define this destination as the R-star or neutral interest rate. This is the rate that balances desired savings and investment and would apply when output reaches an economy’s potential and inflation reaches target. It cannot be seen but can be estimated.

We know R-star is keeping the Fed busy because Chairman Jay Powell said last year that he was “sailing by the stars under cloudy skies.” The neutral rate was unknown, he said, but the Fed’s policy rate at the time (and today), between 5.25 percent and 5.5 percent, was restrictive and “well above traditional estimates of the neutral policy rate.”

Even if the median Fed official estimates the R-star at 2.6 percent, the important question, with a resilient U.S. economy and higher-than-expected inflation, is whether the committee can tell. The dilemma also applies to all other central bankers.

Easy days

There was a time when all estimates of the neutral rate, whether based on market prices, structural models, or something in between, gave similar answers. The R-star had been high and declined until the pandemic.

The following well-known chart shows market rates for 10-year government bonds in the US, Eurozone, Japan and the UK between 1980 and the 2019 pandemic. This can be seen as a very rough approximation of the R-star and other economic estimates given. similar results.

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

Economists and policymakers have told many stories explaining the decline in nominal and real interest rates, including inflation control, secular stagnation, the savings glut of Asian economies, rising inequality increasing the savings and falling productivity and growth rates reducing the desire for investment.

Borrowing costs have increased since the pandemic, complicating the situation and raising the question of how much has R-star also increased? Do these stories still make sense or have we entered a world of consistently higher interest rates?

A world of disagreement

I’m going to simplify here, but we have a big discrepancy. Market data, as above, suggests that neutral interest rates have risen sharply. These are reproduced in much more sophisticated estimates of R-star. The alternative opinion, generated by more structural models, such as the IMF estimates or those of the New York Fed, asserts that nothing has changed. Soumaya Keynes wrote a fabulous article last year about the differences in modeling.

The general reasoning behind this divergence of views is that R-star estimation methods that show little change amplify the importance of long-term concepts that change slowly, such as potential growth rate or demographics. , while those which show that the world has changed give more weight to financial market prices.

This would be difficult enough if there weren’t horrendous estimation problems and fundamental uncertainties about the economic significance and drivers of R-star.

Nightmares for economic researchers

It is difficult to estimate things using econometrics. There are always data problems. These are extreme when it comes to R-star.

In March, for example, the Bank for International Settlements noted that the one standard deviation range (in which the true value will only lie 68% of the time) around the Richmond Fed’s R-star estimate for the United States was 1.73 percentage points. . This is 3.2 percentage points for the New York Fed model. For the Eurozone, these figures reached completely unusable figures of 5.6 and 12 percentage points.

In other words, the New York Fed model was reasonably confident that eurozone nominal interest rates were heading towards a value between -4.7 percent and 7.3 percent . Bright.

Uncertainty is, in many ways, worse than that. These models don’t even agree with their earlier versions, in part because the main determinant of R-star in the model is the potential growth rate – itself a made-up number.

The New York Fed is extremely transparent about its results and publishes them every quarter. I gathered all of his data to produce the animated graph below.

When you play the animation, the same model for the same time period gives different results depending on when it was estimated. This is partly due to revisions to the economic data themselves, a regular difficulty for economies. More recently, changes in model specifications are also important and show that the model is unstable after the pandemic for all countries. The New York Fed has stopped publishing its results in the United Kingdom.

If you are a central banker and you work with a number in mind for where interest rates are going and then it changes significantly in the new estimates, you have a problem. A big.

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

Even more fundamental models, such as those produced by the IMF, are unfortunately not more reliable. As Claudio Borio, head of economic studies at the BIS, and his colleagues documented in 2017, the long-term forces that explain the decline of the R-star between 1980 and the 2010s did not operate in the during previous periods.

This strongly suggests that the model is flawed. This point was made forcefully in a recent talk at the US Monetary Policy Forum by Jeremy Stein, a Harvard professor and former Fed governor.

Nightmares for central bankers and markets

This is not the end of the difficulty of researching R-star, as market data also poses a serious problem. The sharp decline in all interest rates between 1980 and 2019 did not occur uniformly.

A remarkable article by Sebastian Hillenbrand shows that the entire decline since 1989 occurred in the three days surrounding the Fed meetings. At any other time, there has been no decline in borrowing costs.

If you don’t believe it, the ECB replicated Hillenbrand’s data and the chart below shows that the two data sets are essentially identical.

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

This means that the Fed clearly plays an important role in influencing R-star’s market indicators. This means that if managers look to the market for an R-star estimate, they will look at their own actions. They just look at the mirror.

More fundamentally, the research calls into question the entire concept of R-star because it is theoretically supposed to be an anchor set by fundamental forces balancing saving and investment.

If, on the other hand, Fed policy directly influences R-star, the honest thing to do would be to think about the possibility of regrouping the concept of interest rates towards which we tend. The same logic applies if governments influence R-star with their fiscal policy stance.

Long before Powell used the cloud analogy, Borio said, “When the sky is cloudy, it is difficult to see where the stars are and even how many there are. »

Others have rationalized this result by imagining less catastrophic consequences for central bankers. ECB board member Isabel Schnabel said that while the results were “confusing,” they would not be difficult to explain if “financial markets…. . . ultimately look to the central bank for information on the long-term development of the economy.”

This is forward guidance on steroids that suggests financial markets have few ideas of their own beyond what they have learned from august central bankers.

But there are other theories. Perhaps central banks play an important role in shaping R-Star through their actions, not their words. If low interest rates create zombie companies that don’t invest, that can drive down the R-star and become self-reinforcing. Or, as Stein thought, perhaps low interest rates had become addictive and were no longer as stimulating as before.

The result

It is clear that numerical estimates of R-star are not worth much, although economists need to think about this concept. We don’t know where interest rates from the Fed or other central banks are heading. We lost the anchor we thought we had, but probably never did.

This is not to say that the economic analysis of interest rates is hopeless. Central banks must constantly assess whether the monetary policy they implement is expansionary or restrictive in the short term. There are many measurements they can look at to see how the transmission mechanism is working.

What they shouldn’t do is snatch an R-star number from a model and give them credit they don’t deserve.

What I read and watched

A graph that counts

While almost everyone thinks the Fed now needs to pause a little longer and assess the inflation outlook, Tej Parikh, our leading economics editor, thinks everyone is panicking unnecessarily. He’s rather disappointed that Powell now thinks it takes longer to see disinflation, which he says is still on track. In an important chart, it shows that U.S. wage growth continues to moderate.

You see a snapshot of an interactive chart. This is probably because you are offline or JavaScript is disabled in your browser.

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