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
“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.
Attempting to placate the markets a few weeks later, Powell stated that the same level of rates was “just below the broad range of estimates that would be neutral for the economy”. Yet again, markets were mistaken in that they focused on the “just below”, whereas they should have paid more attention to the term “broad range”.
The Fed’s projections are actually for a range where the interest rate will sit in the long run. That range is 2.5-3.5 per cent, hence the 3 per cent midpoint, and the current policy rate is clearly just below that band. When combined with a weaker US and slowing global economic data, this dovish tilt from the Fed was construed as a reason for the flattening of the yield curve and added market angst.
However, the real reason part of the yield curve has inverted is not a more dovish Fed – the statements have been more factual than anything – but rather that the Fed is increasingly becoming dependent on how the economic data evolves rather than following a predetermined course for rates. As the sugar-high of fiscal stimulus starts to wear off and economic activity is expected to slow, the Fed will start to communicate that a softer growth outlook could lead to a pause in the hiking cycle. If this is the case, we are likely to see a rotation into longer dated bonds and an inversion of the yield curve. That said, even under the other scenario, the yield curve is likely to invert.
If economic growth were to cool from 2018’s high but still manage to remain above historical averages, then the Fed would presumably keep raising the rate well past its neutral level, pushing the short end of the curve higher until it eventually inverts.
The nature of “R-star”, or the neutral rate, is an opaque one. The reality is that no one really knows what the precise level is until after it has been reached. What we do know is that market anxiety rises in the context of the late-cycle narrative. We also know that a miscommunication from the Fed can have amplified market effects, even if recent statements contain a degree of truth. This has been the shallowest and longest Fed hiking cycle the market has ever experienced and it’s unlikely that we are at the fabled “R-star”.
Rates will continue to rise and be a focus for markets in 2019, but the policy still remains accommodative.
Kerry Craig is a global markets strategist at JP Morgan Asset Management