Macroscope | The Fed’s quest for a ‘neutral’ interest rate has put the markets on edge. It shouldn’t

Kerry Craig says with the markets jumping at every Fed statement, anxiety is growing over the Treasury yield curve flattening or, worse, inverting. A closer look shows Fed policy will remain accommodative

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Traders work on the floor of the New York Stock Exchange on December 6. A miscommunication from the Fed can have amplified market effects, even if the statements contain a degree of truth. Photo: AFP

Published: 4:00pm, 7 Dec 2018Updated: 10:23pm, 7 Dec 2018

“Twinkle twinkle little star, how I wonder what you are?” The opening line from this children’s nursery rhyme has a surprising amount of relevance to today’s markets.

The star in question is actually the “R-star” – meaning the level for interest rates that separates a loose monetary policy from a restrictive one. Conceptually it’s relatively straightforward, referring to the real short-term interest rate that would prevail in an economy at equilibrium, or the interest rate you would expect in “normal” conditions.

This bit of jargon typically thrown around by policymakers and economists actually matters because it is at the centre of an ongoing debate over central bank actions and their role in the real economy. Just how far the US is from reaching the so-called “R-star” neutral rate may influence how many more rate increases we could expect from the US Federal Reserve before the cycle ends – an uncertainty that has exacerbated recent market volatility.

Fed officials are seemingly tripping over their own tongue when it comes to explaining their views. Back in October, Fed chair Jerome Powell stated that “we’re a long way from neutral at this point”.

At the time, this seemed like a reasonable statement, given that, in the Fed’s view, the midpoint for the long-term interest rate is 3 per cent and the current interest rate is between 2 per cent and 2.25 per cent. But markets aren’t always so reasonable and the anticipation of further hikes contributed to a horrid October.

US Fed chair Jerome Powell said in early October that rates were far from being neutral, but a few weeks later, in an attempt to placate the markets, he said the same level of rates were “just below” neutral. Photo: EPA-EFE