July 5, 2023
Federal Reserve policy makers and investors aren’t always on the same page, but when it comes to their expectations of where rates will end up over the long haul, they agree: much lower than they are now.
And they might all be wrong, a mistake that could force the Fed to radically reassess its rate expectations in addition to keeping longer-term interest rates—such as on the 10-year Treasury and mortgages—significantly higher than they were before the pandemic.
In projections released after their June rate-setting meeting, the median forecast among Fed policy makers put the “longer run” level of the central bank’s target on overnight rates at 2.5%. A survey of primary dealers—banks and other firms that deal directly with the Fed—and a separate survey of large investors, both conducted by the Federal Reserve Bank of New York in May, showed the same median forecast.
The longer-run rate forecasts equate to an assessment of what the target rate would be if inflation was at the Fed’s 2% objective and employment was as high as possible without driving inflation higher. When thinking about this just-right rate, economists typically put it into inflation-adjusted, or real, terms. In this case, subtracting out the Fed’s 2% inflation objective, it would be 0.5%. Economists call this real, neutral rate “r-star,” a technical term with a side effect of lending itself to puns in research notes of the sort the Heard on the Street would never stoop to.
The fault in r-star is that while economists have put a lot of effort into modeling what it might be, it cannot be directly observed. Worse, r-star models typically include unobservable factors that must themselves be estimated, such as the difference between current gross domestic product and “potential GDP,” or the level of GDP at which the economy would be in equilibrium.
One consequence is that different models can spit out significantly different estimates. In early 2016 research, for example, a model from Fed economists Benjamin Johannsen and Elmar Mertens put r-star in the fourth-quarter of 2015 at about 0.95%. But a separate model from the late Fed economist Thomas Laubach and John Williams, now the president of the New York Fed, at around the same time put r-star more than a full percentage point lower at negative 0.1%.
The latter model and a newer one that includes contributions from economist Kathryn Holston are widely followed, probably in part because of Williams’s stature, and because they were regularly updated on the New York Fed’s website until pandemic distortions made them go haywire. With some rejiggering, they are both getting published again. The Holston-Laubach-Williams model lately estimates r-star is at 0.58%—right around where policy makers and investors say it is.
It is also not far from the 0.95% it held before the pandemic, which on a gut-check level is surprising. Consider: In response to the financial crisis, the Holston-Laubach-Williams model estimates r-star fell from 2.6% in the fourth-quarter of 2007 to 0.7% in the second quarter of 2009, yet the pandemic was arguably at least as consequential as the crisis in terms of the shifts it generated in the economy’s composition.
Moreover, it was consequential in ways that seem they could push r-star higher, says Jonathan Wright, a former Fed economist now at Johns Hopkins. He notes in particular the large amount of fiscal spending the pandemic provoked. The cash injections that businesses, households and state and local governments received would likely have boosted r-star since it takes higher rates to restrain the economy. Measures such as the clean-energy tax credits included in last year’s Inflation Reduction Act could keep some of that fiscal impulse going.
The reduction in income inequality prompted by shifts in the labor market could also play a role. Poorer workers with more unmet needs are more likely to spend the money they earn than sock it away, so this should also fuel inflationary forces, pushing r-star higher.
A third factor, productivity, is a wild card, because productivity measures, such as the typical worker’s output per hour, have been badly distorted by the pandemic and its aftermath. If productivity ends up being higher—say because employers have invested more in labor-saving technologies, or because generative artificial intelligence meets some of its hype—that would make the economy run faster and generate demand for more investment by businesses. That in turn should push r-star higher.
If r-star turns out to be higher than estimated, it would have important consequences. If it is 1.5%, for example, the Fed’s longer-run range on rates would settle a full percentage point higher than policy makers now forecast. For the central bank, this would be mostly good news, because it would be less likely to need to take rates all the way back down to zero when trouble hit. But for investors who believe rates are destined to go back to where they were before the pandemic, there could be a painful rethink.
This article was originally published in The Wall Street Journal on July 5, 2023, and written by Justin Lahart. Image courtesy of AL DRAGO/BLOOMBERG NEWS.
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