Is Good News, Bad News?

Investors were rattled on Wednesday after Federal Reserve Chair Jerome Powell suggested a pause in rate cuts and hinted that the total number of reductions might be less than expected. His remarks signal a significant shift in monetary policy, as the Fed edges closer to what economists call the "neutral rate."

  • The neutral rate of interest is the rate that keeps the economy at full employment with stable inflation. It is not directly observable but inferred from economic behavior.
  • Strong borrowing and spending paired with rising prices suggest rates are below neutral, while weak activity and falling inflation indicate rates are above it. Powell framed recent rate cuts as an adjustment to reach neutrality.

Earlier this year, determining the neutral rate wasn’t critical because interest rates were intentionally restrictive. The Fed raised rates aggressively in 2022 and 2023 to cool down the economy and curb inflation. However, after a full percentage point reduction in rates and a resilient economy, policymakers are recalibrating. Powell hinted that the neutral rate may have risen in the post-pandemic economy.

A Higher Neutral Rate?

Powell suggested rates might not return to pre-pandemic lows, when some countries issued bonds with negative yields. According to Jerome Powell, the neutral rate is probably significantly higher than it was back then. Economists cite several factors pushing the neutral rate higher:

  • Increased government deficits reducing private savings.
  • Higher investment demand driven by the green-energy transition, supply chain diversification, and artificial intelligence.
  • Structural shifts stemming from the pandemic-era economic shock.

Since the 2008 financial crisis, neutral rate estimates had been revised downward due to demographic headwinds and a lack of investment demand. However, in the last year, estimates have gradually risen, with the Fed’s median projection climbing to 3%—up from 2.5% in 2019. Notably, eight out of 19 Fed officials now estimate neutral at above 3%.

Policy Caution and Economic Shifts

Powell has long emphasized that the neutral rate is best identified by observing its effects, cautioning against overly precise estimates. Some Fed officials, including Dallas Fed President Lorie Logan, warned against cutting rates too far below neutral, as doing so could require sudden hikes if inflation resurges.

  • Jason Thomas, chief economist at Carlyle Group, noted that recent resilience in the economy could reflect temporary factors, like increased immigration and pandemic-era borrowing at low rates.
  • However, sustained growth might indicate a “new regime” of higher neutral rates.
  • Higher neutral rates suggest that borrowing costs, including mortgage rates, might stay above pre-pandemic levels. Recent data, such as rising labor productivity, point to structural economic changes. This challenges the narrative that the Fed’s 2022-23 rate hikes alone drove the higher rates.

According to former Boston Fed President Eric Rosengren, the recent rate cut positions rates near the potential upper bound of the neutral interest rate, suggesting a period of observation may follow.

What It Means For Investors

The era of ultralow interest rates may be over. With the neutral rate seemingly higher than in the past decade, further rate cuts could be limited, leaving investors and businesses to adjust to a landscape of elevated borrowing costs and cautious monetary policy.

  • The U.S. dollar is expected to remain strong over the next 12 to 18 months as the global economy faces growth challenges while the U.S. economy continues to surge ahead.
  • Private equity groups could face mounting pressure in the coming year, as their investment strategies and exit opportunities rely heavily on cheap financing, which may become increasingly scarce in a high-rate environment.
  • For stocks, the outlook remains bullish on U.S. equities. Corporate earnings are bolstered by a robust economy, and many companies have demonstrated their ability to grow and fund operations even with elevated interest rates.

Moreover, speculative investments, including high-growth technology firms, have successfully reduced expenses and increased profits over the past two years, further strengthening their position.

Disclaimer

Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

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Photo by Vladimir Solomianyi / Unsplash.