It Would Be a Whole New Economy If the Fed Pauses at ‘Neutral’

(Bloomberg Opinion) -- The biggest debates in Federal Reserve circles right now is where the level of “neutral rates” is, and whether officials should stop increasing interest rates once they get there. Halting interest rate increases at the Fed’s estimate of neutral would represent a change from how the Fed has conducted policies in the last two cycles, and would shift economic risks from workers to companies.

For most of the time since the inflationary crisis of the late 1970s, Treasury rates have generally been a fair amount higher than the level of inflation, meaning that real interest rates — the return bondholders would earn in excess of inflation — have been strongly positive. This has particularly been the case toward the end of economic cycles when the unemployment rate was low and financial excesses have been apparent: the stock market in the late 1990s, and the housing and credit markets in the mid-2000s.

This policy approach has had pros and cons. A high level of real interest rates has helped establish and maintain the Fed’s credibility on keeping inflation low and stable. A lower level of real interest rates would have put downward pressure on the dollar, so one could say that high real interest rates have maintained the purchasing power of the dollar in global markets. But the flipside is it has made U.S. domestic companies and workers less competitive in global markets than they otherwise would have been, and has kept labor markets weaker than they would have been too.

Several members of the Fed, in thinking about how monetary policy should evolve over the next several months, are challenging this approach. At last Friday’s Jackson Hole retreat, St. Louis Fed President James Bullard joined his Atlanta Fed colleague Raphael Bostic in saying that the Fed should not “knowingly invert the yield curve,” meaning the Fed should try to keep short-term interest rates below the level of longer-term interest rates. Two other regional bank presidents, Dallas Fed President Robert Kaplan and Cleveland Fed President Loretta Mester, have suggesting pausing interest rate increases once rates hit their estimates of neutral — the level at which monetary policy is neither accommodative nor restrictive.

There’s an argument that “pausing at neutral” is more a reflection of current conditions — while the unemployment rate is low, inflation has not yet shown signs of breaking out, and financial excesses are not yet a major concern of the Fed’s — than a change in how they conduct policy.

But Chairman Jerome Powell’s Jackson Hole speech shows a path for how the former could lead to the latter. In it, he talks about how Chairman Alan Greenspan essentially went with his gut, and in 1996 when some were calling for tighter monetary policy he had a hunch that the wonders of the “new economy” were about to be unleashed, and that a pickup in productivity growth could support faster overall economic growth without a worrisome increase in inflation. And Greenspan was right. It’s possible that six or 12 months from now, even if the unemployment rate continues to fall and inflation picks up somewhat, Powell could argue a similar position and feel that higher inflation is transitory, and that pausing interest rate hikes at neutral is the right course of action even if more rigid quantitative models argue for further increases.

That’s what markets are increasingly looking for. Eurodollar futures markets currently only anticipate about three more interest rate increases total for this cycle, fewer than the six or so that the Fed is projecting by the end of 2020.

Pausing at neutral would be good news for workers but would shift risks elsewhere in the economy. In the past, with the Fed willing to let real interest rates become strongly positive, companies had the luxury of knowing that the Fed would keep inflation contained, and would have been wise to wait for the Fed to create a recession rather than investing too much at the peak of an economic cycle. Workers, on the other hand, have no good way to take precautions if a surge in unemployment was coming. The best they could do was cut back spending to build a nest egg in recession that would likely be insufficient.

But say that now the Fed is willing to let inflation run hot for a while, maybe even choosing the approach preferred by the St. Louis and Atlanta Fed presidents and never knowingly inverting the yield curve. Rather than high real interest rates and a stronger dollar, neutral real interest rates might mean a weaker dollar and higher prices for commodities and raw materials. For workers this might mean less chance of becoming unemployed but at the cost of their paycheck not going as far as before.

Consider the case of an industrial company, though. Until a high real interest rate regime they could just sit back and wait for recession. In a neutral rate regime and the economy running hot, they instead find themselves capacity-constrained with the cost of raw materials surging. What to do now? At first, they might choose to wait it out — sell the inventories they have in stock, but not pay high prices for raw materials that could turn out to be fleeting. With inventories detracting over a point from GDP growth in the second quarter of 2018, it’s possible some of that occurred. But eventually they’ll run out of inventories and they’ll be in the uncomfortable position of either paying up for raw materials or new capacity only to misjudge an eventual demand decline, or running out of things to sell and having a sales shortfall. All of a sudden, there’s a greater cost to being wrong.

Extrapolating this dynamic out to the economy at large, we could find ourselves with a more volatile economic cycle as companies find themselves having more frequent bouts of inventory surpluses and deficits, and raw materials spiking at times and declining rapidly at others. It becomes more problematic for supply chains. The average level of inflation over time doesn’t even need to change dramatically for this to occur.

On balance, assuming inflation doesn’t spiral out of control, such a policy shift would be a welcome development, but it will lead to different economic and financial market dynamics than we’ve experienced in a long time.

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net

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

Conor Sen is a Bloomberg Opinion columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

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