The Fed’s No Longer Guided by Concept of Neutral Rates
(Bloomberg Opinion) -- The Federal Reserve’s “r-star” has gone full supernova. New York Federal Reserve President John Williams, its key proponent, made clear in a speech late Friday that the neutral interest rate is no longer a guiding star for monetary policy. This means a federal funds rate in the range of what is considered neutral has no special significance as far as policy is concerned.
That is hawkish relative to any expectations that the Fed would pause as policy rates approach a level that neither stimulates nor restricts the economy. And it again highlights the importance of the incoming economic data. The Fed isn’t holding your hand anymore.
Williams’s attachment to r-star cannot be overstated. At a professional level, it has been a key element of his research agenda. As recently as May he said that for “the moment, r-star continues to shine brightly, guiding monetary policy, but hold steady, low on the horizon.” The moment quickly passed. Last week, he tossed aside the metric, saying that it has “gotten too much attention in commentary about Fed policy.” A remarkable shift after just two 25-basis-point rate increases since his May comments.
Williams now argues that r-star only served as a useful metric when policy rates were far below neutral. Now that policy is closing in on r-star, it actually becomes a less clear concept because of the uncertainty of neutral-rate estimates. The concept is just one of many tracked by the Fed. What’s the guiding metric now? Williams says he “will be guided by our dual mandate, a heavy dependence on data, and a steadfast commitment to transparency.” With the Fed now operating in what central bankers view as a normal economic environment, policy is now all about the data.
Williams’ speech marks the end of a transition in policy away from explicit forward guidance. It began this past August with Fed Chairman Jerome Powell’s Jackson Hole speech in which he noted the uncertainty surrounding estimates of key variables like the neutral interest rate. Fed Governor Lael Brainard pushed this point further in a subsequent speech, adding further uncertainty by differentiating between short- and long-run neutral. It continued in the September Federal Open Market Committee statement with the removal the description of policy as “accommodative.” And it ends with the primary proponent of the r-star concept — Williams — throwing it into the trash bin of crisis-era policy artifacts.
The demise of r-star has two important implications for market participants. First, it has fairly hawkish implications for policy. Had the Fed thought they did not need to raise rates above current estimates of r-star, they could simply have held onto the r-star concept and prepare markets for a pause in the tightening cycle on the basis that policy rates will soon be in the range of those estimates. Instead, they downplay the relevance of r-star. The message is that they don’t think a pause is imminent. If you thought the Fed would pause just because policy is approaching neutral, think again.
The second is that the data should be your primary focus. Arguably, the data was just a sideshow in the early stages of the current tightening cycle. Forward guidance told you that rates were far from neutral. As long as the economy retained even a modest pace of growth, rate hikes would continue. That is no longer the case. The data is the arbitrator of the level of policy accommodation, not some theoretical construct. Brainard made this clear in her recent speech by noting that while she can’t precisely estimate the neutral level of rates, the fact that job growth has strengthened and financial conditions have eased since the Fed began raising rates clearly indicates that policy remains accommodative — and possibly even no tighter than in December of 2015.
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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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