Fed Debate On Neutral Rate Misses The Bigger Picture

(Bloomberg Opinion) -- Federal Reserve policy makers are debating whether to stop tightening monetary policy when interest rates reach a neutral level that neither stimulates nor restricts growth. At this point, there is no easy answer, but central bankers should de-emphasize the level of rates at which they would pause and instead focus on the economic conditions that justify a pause.

The federal funds rate currently sits in a range of 1.75 percent to 2.0 percent. The median policy maker estimate of the neutral rate is 2.9 percent within a wide overall range of 2.25 percent to 3.5 percent. The lowest of the estimates will almost be reached with the next rate increase, widely expected to come Sept. 21. 

Neutral rates present a natural time to pause the tightening process, at least in the eyes of some policy makers such as Dallas Federal Reserve President Robert Kaplan. For others, the case for a pause at neutral is much less compelling. Boston Federal Reserve President Eric Rosengren said recently that “We want to get back to a more normalized monetary policy, but there’s no reason necessarily to pause at any point until we think we’re at the appropriate place for where the economy is.”

Rosengren is correct. There is far too much uncertainty about the path of the economy to assume the Fed will pause when policy rates reach estimates of neutral, particularly the lower estimates. Hence, be cautious of reading too much into claims by central bankers that they expect a pause after three or four more rate hikes. That pause is very conditional on the state of the economy after those increases.

Indeed, many central bankers appear to have fallen into the habit of excessively utilizing forward guidance based on the neutral rate despite the fact that the neutral rate is just an estimate. The Fed might hit that rate and learn that their estimates were too low or too high. We won’t know until we get there. The uncertainty surrounding such estimates was a key element of Fed Chairman Jerome Powell’s Jackson Hole speech a few weeks ago.

Moreover, the typically cited measure of neutral is the longer-run rate. The short-run rate is the key for near-term policy. Fed Governor Lael Brainard emphasized this distinction in a recent speech. She anticipates the short-run neutral rate will rise above the long-run rate, which means that policy rates will exceed neutral. Brainard anticipates continued gradual rate hikes for the “next year or two.”

The forward guidance habit is a difficult one to break given the continued existence of the Fed’s “dot plot” of interest rate projections. The communication challenge for the Fed remains shifting the focus from the projection of rates to the economic story behind that projection. Market participants should be less focused on what level of rates will trigger a policy pause and more focused on what economic conditions will trigger a pause. Central bankers should help push the conversation in this direction.

Talk of a pause is currently more about hope than reality. Incoming data remains far too strong for the Fed to contemplate an end to rate increases. Job growth continues at a rate the Fed believes will eventually be consistent with an overheated economy. And there is no reason to expect pressure on the labor market to alleviate anytime soon. Initial unemployment claims continue to trend downward while the number of job openings reached record high in July. 

Moreover, there is internal pressure from Fed staff to keep boosting rates, and this pressure is likely grow. Contained inflation only goes so far in moderating policy tightening. It can hold the Fed to a gradual path, but won’t stop hikes as long as the economy expands at a pace well in excess of the Fed’s estimates.

For the Fed to initiate a sustained policy pause, they will need a solid reason to believe that past rate hikes are sufficient to temper the pace of growth to more sustainable levels. We aren’t seeing that yet. Consequently, remember that whenever a Fed official looks to future and sees a specific end to rate hikes, that’s just a prediction and not a promise.

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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