Will the Fed's hopes be pinned on the neutral interest rate again, another fatal mistake?

From early March 2022 to August 2024, Federal Reserve officials aimed to significantly tighten monetary policy to reduce inflation, although it was widely expected to lead to an economic recession. They have now successfully achieved this goal, and the economic recession has not materialized.

The inflation rate is approaching 2%, and policymakers' goal is to prevent an increase in the unemployment rate. They intend to achieve this goal by lowering the federal funds rate to a neutral level. At this level, inflation remains subdued, and the unemployment rate remains low. This level is commonly referred to by economists as the neutral rate (R-star or R*).

The issue is that before the Federal Open Market Committee (FOMC) in its policy-setting meeting on September 18 cut the federal funds rate by 50 basis points to 4.75% to 5.00%, the U.S. economy had already nearly achieved this goal. Furthermore, the FOMC hinted at taking more accommodative policies in its Summary of Economic Projections (SEP) by its committee members.

The SEP shows that policymakers' median forecast for the "longer-run" neutral federal funds rate is 2.90%. They collectively believe that in the long run, this will align with a 4.2% unemployment rate and 2% inflation rate. This implies that the actual neutral federal funds rate is 0.9%, much lower than the current level.

Of course, the neutral federal funds rate is purely a theoretical concept. Everyone acknowledges that it is immeasurable and will change over time, depending on many economic factors. Even the FOMC's estimates for this long-term rate range from 2.37% to 3.75%.

Federal Reserve officials were undoubtedly surprised by the apparent weakness in the labor market data released before the September FOMC meeting. However, data released after the meeting showed stronger-than-expected job growth in September, with upward revisions to employment numbers in July and August. Additionally, the unemployment rate fell to 4.1%.

Meanwhile, the "super-core" inflation rate in September (excluding housing from core services) remains well above 2.0%. By the end of 2022, Federal Reserve Chairman Powell stated that this "may be the most important indicator for understanding the future evolution of core inflation."

So why do several Federal Reserve officials indicate that they are still committed to further rate cuts? Apparently, they believe that since inflation has fallen significantly since the summer of 2022, they must lower the nominal federal funds rate to prevent real rates from rising and becoming too tight. They want it to fall in line with their estimate of the true neutral rate. They are concerned that if they allow real rates to rise, the inflation rate will fall below 2%, and the unemployment rate may spike. So they are targeting an unknown neutral rate.

The bond market's reaction to the Federal Reserve's massive rate cut on September 18 speaks volumes. Compared to U.S. Treasury inflation-protected securities, the yield on 10-year U.S. Treasury bonds has surged, and the inflation premium increase is already reflected in the market pricing This raises another question about the relevance of the neutral interest rate after inflation adjustments. Federal Reserve officials intend to lower the federal funds rate because actual inflation has slowed. However, their initial actions seem to be raising inflation expectations in the bond market. Most economists seem to agree that, in theory, the neutral interest rate should be adjusted based on expected inflation rather than actual inflation.

Federal Reserve officials seem to have committed to a series of rate cuts to bring the federal funds rate to neutral, regardless of where its final level may be. Considering that the next FOMC meeting will take place after the U.S. presidential election, this idea seems quite naive. The outcome of the election may have a significant impact on the neutral interest rate, as both presidential candidates have proposed policies that could expand the federal deficit and lead to inflationary consequences.

While fiscal policy is bound to have some impact on the neutral interest rate, Federal Reserve officials seem to believe that only monetary policy matters. Relying on the neutral interest rate alone cannot solve the issues with fiscal policy.

The massive federal deficit in recent years helps explain why the economy did not fall into a recession when the Federal Reserve tightened monetary policy. However, inflation has receded. What if nominal and real neutral interest rates are much higher than what Federal Reserve officials believe? In that case, with the Federal Reserve continuing to lower the federal funds rate, inflation could make a comeback. The message being conveyed to Federal Reserve officials by the bond market is, beware of your reliance on the neutral interest rate.

This article was written by the President and Chief Investment Strategist of Yardeni Research