Even the Fed's Own Research Shows Rates Are Too High

(Bloomberg Opinion) -- New research from the Federal Reserve’s own economists reveal that estimates of the neutral real rate of interest are well below those of policy makers. The low estimates have important implications for policy makers and market participants, suggesting the Fed may still have some hawkish expectations of what can be accomplished in the future despite its dovish turn this year.

The real neutral rate of interest is the rate that is consistent with a balanced economy in the long run. Policy makers use it as a gauge by which to judge the stance of monetary policy. For example, if policy rates are below the neutral rate, the Fed is being accommodative. 

Because the real neutral rate of interest can’t be seen directly, policy makers must use econometric estimates to guide them. The September - and most recent - Summary of Economic Projections of Fed meeting participants shows the median estimate of the longer run interest rate at 2.5%. However, the uncertainty of the estimates is wide, with the overall range at 2% to 3.3%. After accounting for the Fed’s 2% inflation target, this means that policy makers estimate the real neutral rate is 0.5%, ranging from 0% to 1.3%.

In contrast, new research using a global rather than a U.S.-centric model, Fed economist Michael Kiley estimates that the neutral real rate is -1%, well below even the lowest estimates of Fed policy makers. If the real rate is -1%, the Fed has been far too hawkish this cycle and overly optimistic in its campaign to “normalize” rates. This explains why markets reacted so poorly to the Fed’s effort to lift off from the zero-bound in 2015 and the Fed rate hike in December 2018, and with it the indication that more increases were coming in 2019. The Fed simply raised rates too early in the cycle and too far given the depressed levels of the neutral rate. 

The relative aggressiveness of policy would also help explain the persistent shortfall of inflation relative to the Fed’s target. This underscores the importance of Chairman Jerome Powell’s recent commitment to hold off on rate increases until inflationary pressures actually emerge. These new, low estimates of the real rate could help policy makers justify keeping Powell’s promise even if the economy gains more traction in 2020. If so, we have even more reason to believe the Fed is out of the way next year.

For market participants, this research is another reminder that you simply can’t look at the past history of rates as a status quo applicable now. The Fed is not holding rates “artificially low,” but is instead following the equilibrium level of rates lower. That means portfolios based on the assumption that rates will “mean revert” to a 4% to 5% range will likely underperform the overall market. 

Furthermore, the persistent period of low rates creates challenges for both market participants and Fed policy makers in that it may support the conditions for asset bubbles to emerge. The desire to “reach for yield” in this environment may contribute to excessive valuation estimates and a deterioration in underwriting conditions. The Fed will have to weigh how they use regulatory power or monetary policy to contain the risks to the financial system than may evolve.

To be sure, it is difficult to estimate the neutral rate in real time and consequently policy makers and policy makers need to be cautious about how wedded they are to any estimates. Still, the upshot of this research is that even after years of falling estimates of the neutral real rate we may still be too optimistic of how high rates can be pushed in the “new normal” for the economy.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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