Renowned strategist Ed Yardeni: The Federal Reserve should cautiously pursue the "neutral interest rate" to avoid reigniting inflation

Most economists believe that the neutral interest rate should be adjusted based on expected inflation rather than actual inflation. Currently, with a significant decrease in inflation in the United States, the Fed's rate cuts are raising expectations in the US bond market for future inflation.

Prominent strategists believe that if the nominal neutral interest rate and the real neutral interest rate are significantly higher than the expectations of Fed officials, continued rate cuts by the Fed could reignite inflation.

On Friday, October 25th, Edward Yardeni, President and Chief Investment Strategist of Yardeni Research, elaborated on the relationship between inflation and Fed rate cuts in the United States. He stated that fiscal policy will inevitably impact the R-star, and the current actions of Fed officials seem to only focus on monetary policy, hoping that the R-star can solve the issues with fiscal policy. Fed officials rely too much on the "neutral interest rate," which could lead to a resurgence of inflation.

At a certain interest rate, an economy can maintain low inflation and low unemployment - economists commonly refer to this ideal rate as R-star or R*.

The issue is that before the Fed's 50bp rate cut in September, the US economy had already reached a state of low inflation and low unemployment, yet the FOMC hinted at more easing policies in the quarterly economic forecast summary.

The summary shows that FOMC members' median forecast for the "long-term" neutral interest rate is 2.90%. They unanimously believe that this level is consistent in the long term with a 4.2% unemployment rate and a 2.0% inflation rate.

This means that the actual neutral federal funds rate is 2.90% - 2% = 0.90% (actual neutral rate = nominal neutral rate - inflation rate), which is much lower than the current level.

Before the September FOMC meeting, US economic data indicated a relatively weak labor market, causing concern among Fed officials. However, after the meeting, job growth data for September exceeded expectations, wage data for July and August were revised upwards, and the unemployment rate fell to 4.1%. Meanwhile, the "super core" inflation rate excluding housing remained well above 2.0% in September.

So, why do some Fed officials still commit to further rate cuts?

Yardeni suggests that evidently, Fed officials believe that since the summer of 2022, inflation has dropped significantly, so they must lower the nominal federal funds rate to prevent real rates from rising and limiting economic growth.

Fed officials hope to lower the nominal federal funds rate towards their estimate of the actual R-star. They are concerned that if they allow real rates to rise, inflation will fall below 2% and the unemployment rate may soar.

Yardeni believes that Fed officials are overly reliant on the R-star, but while the R-star does exist, the exact value is unknown.

After the significant rate cut by the Fed on September 18th, the 10-year US Treasury yield surged, and the inflation premium also rose, raising another question about the post-inflation adjustment R-star Yardeni stated that Federal Reserve officials intend to lower the federal funds rate due to a moderation in actual inflation. However, their aggressive rate cuts seem to be raising expectations in the U.S. bond market for future inflation to rise.

However, most economists believe that theoretically, the R-star should be adjusted based on expected inflation rather than actual inflation.

The next FOMC meeting will be held shortly after the U.S. presidential election, with both presidential candidates leaning towards policies that could increase the federal deficit and lead to inflationary consequences.

Yardeni mentioned that fiscal policy will inevitably impact the R-star, and the current actions of Federal Reserve officials seem to only focus on monetary policy, hoping that the R-star can solve the issues with fiscal policy - if the nominal and real R-star are significantly higher than the expectations of Federal Reserve officials, continued rate cuts by the Federal Reserve could potentially reignite inflation.

Yardeni added: The signal from the bond market is that relying on the R-star may lead to unexpected consequences