Powell Running Behind the (Yield) Curve in Effort to Ease Policy
Federal Reserve Chairman Jerome Powell has said that he looks to the bond market as a guide to the stance of monetary policy. And what it’s telling him today is that he’s falling behind the curve in cutting interest rates.
The neutral interest rate -- the rate that neither spurs nor curbs economic growth in the long-run –- implicit in Treasury yields has fallen this year even as the Fed has trimmed borrowing costs, economists said.
Powell, who is scheduled to give his latest take on policy in Zurich on Friday, told lawmakers last year that bond yields say something “about what the longer run neutral rate is” -- what economists refer to as R-star.
The central bank is widely expected to lower interest rates later this month after reducing them in July for the first time in a decade in response to slowing global economic growth and muted inflation.
The Fed “has had trouble keeping pace with lowered estimates of the neutral level,” Deutsche Bank Chief U.S. Economist Matthew Luzzetti wrote in a Sept. 3 report. It may “be forced to cut rates more aggressively” as a result.
Analysts use various methods to tease out estimates of R-star from bond yields by stripping out inflation expectations, risk premiums and other factors.
One proxy -- the five-year forward real Treasury yield -- has fallen by roughly a full percentage point since December to effectively zero, according to calculations by Wrightson ICAP LLC’s Lou Crandall.
In contrast, the Fed has so far only cut rates by a quarter percentage point, to a target range of 2%-2.25% for federal funds. Based on an average inflation rate of around 1.75% over the last 20 years, that works out to a real yield of as much 0.5%.
Market-based estimates of the neutral rate have dropped as investors have grown gloomier about the economy’s longer-run prospects, possibly in response to the deglobalization shock triggered by President Donald Trump’s trade policy.
“The Treasury market is taking a grim view of the long-term potential growth for the U.S. economy,” Roberto Perli, a partner at the research firm Cornerstone Macro LLC, wrote in a Sept. 3 note.
A paper presented at the Kansas City Fed’s Jackson Hole conference last month argued that global forces play a large role in determining the level of neutral rates in the U.S. and other industrial countries.
A trade war could certainly qualify as one of those, said Alan Taylor of the University of California, Davis, who co-authored the paper with San Francisco Fed economist Oscar Jorda and who observed that yields have been falling worldwide.
The steep drop in long-term interest rates has caught the attention of Fed policy makers.
Dallas Fed President Robert Kaplan called the dramatic decline a “reality check” and noted that the yield on the 30-year Treasury bond is now below the federal funds rate.
That suggests that “I ought to be open minded and constructive about needing to adjust the policy rate” set by the Fed, he told American Public Media’s Marketplace radio show on Aug. 28.
Fed policy makers have been ratcheting down their estimates of the neutral rate in recent years and could lower them again when they provide an updated assessment at their Sept. 17-18 meeting.
Behind the markdown: an aging society and a slowdown in productivity growth that’s depressed credit demand and boosted desired savings.
While Powell has stressed the uncertainties surrounding specific estimates of R-star, he’s portrayed its fall as a dilemma since it reduces the scope for the Fed to lower rates in a recession.
“A low neutral interest rate presents both near-term and longer-term challenges,” he told the Jackson Hole conference on Aug. 23.
©2019 Bloomberg L.P.