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What You Should Know About the Quest for 'Neutral Rate of Interest'

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Monday, 26 Jun 2017 01:51 PM

As the Federal Reserve gradually normalizes its monetary policy, market participants will hear a lot more about r*, the “neutral rate of interest,” which helps equilibrate financial markets when the economy is growing at potential and inflation remains contained and stable.    

Should central banks hike interest rates well beyond this level, they will harm growth, threaten recession and deflation, and impose avoidable costs on society. Should they maintain rates below that level for too long, they will run the economy too hot, see future inflation eat away at the purchasing power of households, and also risk financial market instability that would further harm social welfare. 

This potential boom-bust tightrope also relates to why r* is important for markets. A gradual convergence of the policy rate to that level would allow, to adapt the phrase of Bridgewater Associates’ Ray Dalio, a “beautiful normalization” of monetary policies that is consistent with market stability and soundness.

Should central banks overshoot r*, they will hamper the improvement in economic fundamentals needed to validate existing asset prices, thus risking market instability as prices ultimately converge back down to the weaker economic conditions. And should they instead undershoot r*, they risk fueling bubblish financial conditions that not only render asset prices unsustainable over the medium-term but also threaten the real economy as markets subsequently collapse in what, judging from history, could be a sudden and disorderly fashion.

Here are the 10 key things to know about this concept:

  1. As r* acts as the North Star for the gradual normalization of policy rates, it also helps to anchor market expectations about the destination of the front end of the yield curve, though not the exact path and precise shape of the curve in its entirety.
  2. The determinants of r* are primarily domestic and include such secular and structural variables as productivity, demographics, regulation and financial deepening. Nonetheless, international influences have been playing a larger role in a world of high financial globalization with global common factors becoming more important. Also of importance is a monetary policy stance that has been forced in recent years to try to compensate for shortfalls elsewhere (from the relative paralysis of fiscal and structural reforms to the worsening of inequality that lowers the economy’s marginal propensity to consume).
  3. This mix of domestic, international and policy factors has an important impact on the relationship between interest rates and the exchange rate. The greater the domestic influences, the stronger the relationship between moves in r* and in foreign-exchange markets.
  4. Once thought to be relatively constant, including under the Taylor Rule that has guided the thinking of many central bankers over the years, the level of r* is believed to have declined significantly since the global financial crisis. This has been highlighted in work by Richard Clarida, my former PIMCO colleague and Columbia University professor, and others such as Thomas Laubach and John Williams, as well as the International Monetary Fund and the Federal Reserve system. But its precise specification remains the subject of much debate, adding to the even more contentious discussion about the desirability and feasibility of a regime shift to a rule-based monetary policy.
  5. Amplifying the analytical challenges is the fact that r* is not directly observable. It must be deduced from models that incorporate both economic and financial variables that cover both the public and private sectors, domestic and foreign.
  6. Another challenge is the notion that r* is likely to be time varying. As such, central banks and markets can find themselves trying to deduce, and aiming for, a moving target.
  7. Too sharp a fall in r* confronts central banks with the problem of the “effective lower bound” -- that is, a practical limit to how low/negative nominal interest rates can go. An additional complication is that many of the structural and secular factors driving down r* are outside the influence of monetary policy.
  8. If other policy tools remained sidelined by political polarization, as has been largely the case in recent years, activist central bankers are likely to continue to feel compelled to experiment with other tools, particularly balance sheet measures (asset purchases) and forward policy guidance. That will render r* more unstable and harder to infer.
  9. To the extent that r* has materially fallen, and the vast majority of indicators suggest that this is the case, systemic adaptation will take time. Important aspects of the financial system, and the implicit and explicit contracts that are associated with them, were constructed on the basis of a higher r*. The most visible of these is the institutional set up for providing households with long-term financial protection products such as life insurance and retirement.
  10. While the r* concept is more relevant for advanced countries with mature financial systems, many emerging economies cannot avoid the consequences of related policy shortfalls even though these would be well beyond their borders. An r* undershoot would lead to surges in capital inflows that can destabilize emerging economies’ domestic financial systems. By contrast, an overshoot risks disruptive capital outflows.

For all these reasons, r* has consequences for overall social welfare, as well as private sector profits and losses (P&Ls) in the U.S. and elsewhere. These potential outcomes make the quest for the neutral rate of interest particularly interesting as success is both important and, at least so far, elusive.

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

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He was chairman of the president's Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include "The Only Game in Town" and "When Markets Collide."

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As the Federal Reserve gradually normalizes its monetary policy, market participants will hear a lot more about r*, the “neutral rate of interest,” which helps equilibrate financial markets when the economy is growing at potential and inflation remains contained and stable.    
neutral, rate, interest, fed
Monday, 26 Jun 2017 01:51 PM
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