The Market Could Be Sleeping on Rate Hikes Again In other words, markets systematically underestimate how high rates will go in a given cycle. At least in the US, markets typically stop at the neutral-rate estimate when they’re assessing the future path of interest rates. Markets struggle to reconcile the terminal rate and neutral rate, too. As a result, central banks have a tendency to overshoot: they almost always end a cycle with rates too high, producing a slowdown and often a recession. The problem is that there’s no way to know what the neutral rate is in real time. The Terminal Rate: Where Will the Cycle End?Įvery central banker wants to end rate-hike cycles with a terminal rate that’s equal to the neutral rate so that the economy is in stable equilibrium. We don’t think the FOMC is ready to bump the neutral rate up yet, but even so, the market could be underestimating where rates will end up this cycle-a.k.a. This would signal the market that there’s more room to hike rates in the next few years than is currently expected. Some analysts think the cyclical component will push the neutral-rate estimate up as the economy improves. But there’s also a cyclical element pulling the neutral rate down: the interest rate that the economy can withstand is lower when growth is slower. Why has the neutral rate come down? Mainly because potential economic growth rates are declining as American society ages. Over the last few years, the Fed has reduced this estimate sharply, from 4% when the first set of forecasts was released to the current 2.8%. Think of it as an equilibrium rate what would the fed funds rate be if growth and inflation were both at their natural rate on a stable basis?Įach quarter, the FOMC forecasts this interest rate, known as the long-run fed funds rate. In other words, it isn’t boosting growth and isn’t slowing it down. The neutral interest rate is the rate at which monetary policy is neither accommodative nor restrictive. The Neutral Rate: Monetary Policy’s Sweet Spot Two key concepts come into play here: the neutral rate and the terminal rate.
What is significant is where the committee ends this rate cycle. Whether the committee raises rates four times this year ( our longstanding forecast) or three times really isn’t economically significant. We think the intense focus on the near-term dots is misplaced. With that outcome nearly certain, most of the speculation is focused on the path of the fed funds rate-specifically, the “dot plot” that signals the committee’s rate expectations-for the rest of 2018. We think it’s more important not to overlook this cycle’s endgame.Īs the Federal Open Market Committee (FOMC) meeting kicks off, the market is pricing in a 96% probability of a quarter-point hike in the official short-term rate. There’s not much suspense around this week’s Fed meeting: the fed funds target rate is almost certain to rise by 25 basis points.
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