Are interest rates neutral? The markets certainly hope so

Comment

One of Federal Reserve Chairman Jerome Powell’s unscripted remarks during his Wednesday press conference – that interest rates have reached a “neutral level” after the 75-point interest rate hike just announced – is sure to generate much discussion among economists in the weeks and months to come. Judging by the reaction of the markets the minute he made that remark, it is clear what conclusions the vast majority of investors want these economists to reach.

Neutral is shorthand for the crucial notion that the level of interest rates is consistent with a monetary policy that is neither restrictive nor expansionary. Combined with the Fed’s dual mandate, it signals monetary policy that is about to be set to ensure maximum employment and price stability.

In today’s world, that translates to markets in the view that the Fed now believes it has already done most of what is needed to tighten monetary policy to deal with what Powell himself described it as inflation that remains “far too high” and is inflicting “considerable hardship” on Americans.

Given this interpretation, it should come as no surprise that immediately after Powell uttered the word “neutral”, stocks, bonds and the dollar all moved significantly and exactly as the textbooks suggest: stocks jumped, with major indexes ending the session 1.4% to 4.1% higher; bond yields fell, with two-year treasury bills falling below 3% and the curve inversion for two-year and ten-year treasury bills moderating to 20 basis points; and the dollar weakened, with the DXY index falling to 106.4.

Each of these moves serves to ease financial conditions. No wonder markets have brushed aside other unscripted remarks from Powell that are hard to immediately reconcile with his assertion that rates are neutral. This included the likelihood of a higher natural rate of unemployment; the considerable degree of economic uncertainty; the need for the Fed to go “meeting by meeting” on its policy decisions; and the difficulty of providing clear policy directions for the future.

Count me in among those who hope Powell is entirely right that rates are already neutral. This would improve the odds that the Fed would be able to calm the economy, thereby reducing inflation with limited damage to livelihoods and without triggering worrying financial instability.

I don’t have an accurate estimate for neutral for the very reasons Powell mentioned regarding the unusually high level of uncertainty and changing structural parameters of the economy. As for the general neighborhood for this level, I have a hunch, but I’m far from certain, that we’re always below.

I hope I’m wrong. Otherwise, it will unfortunately end up amplifying my oft-repeated concerns about the collateral damage to the economy and livelihoods, especially those of the most vulnerable segments of society, from a Fed that has taken too long to understand and react appropriately to inflation.

More other writers at Bloomberg Opinion:

• Why the Federal Reserve should keep an open mind: Editorial

• Do you think the Fed hasn’t done enough? Think Again: Nir Kaissar

• The Beast of Inflation will no longer sit still: Allison Schrager

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and President of Gramercy Fund Management. He is the author of “The Only Game in Town”.

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