COLUMN-Fed neutral rate forecast reveals ‘transient’, pivot at last: McGeever

By Jamie McGeever

ORLANDO, Fla., Sept 28 (Reuters) – Investors are fearful and bond markets are crashing, as expectations of a pivot from the Federal Reserve evaporate and the extent of next year’s easing priced into the interest rate futures curve SA declining to less than 25 basis points.

The Fed is embarking on its most aggressive policy tightening campaign in 40 years and after months of pushback, investors have thrown in the towel: everything they do now – mostly selling – is anchored in the mantra ‘don’t fight the feds’.

But if the Fed was worried about financial conditions not tightening enough to help it overcome sticky inflation – then it could reasonably feel that the recent bond market will succeed it in spades. Global market chaos will only emphasize that point.

Furthermore, while the US central bank is currently essentially pursuing a single mandated policy to reduce inflation regardless of the consequences, its long-term structural view of the economy and inflation remains unchanged.

Updated projections from the Fed’s policy meeting on September 20-21 show that rate setters’ expectation for the economy’s interest rate equilibrium rate over time remained at 2.5%.

Given that the Fed’s inflation target is 2.0%, this suggests that the real interest rate – r-star (r*), the fuzzy, inflation-adjusted interest rate that does not fuel or constrain growth – also unchanged at 0.5%. .

Intuitively, this is surprising. Given how high inflation is, how persistent underlying price pressures appear to be, and how strongly the Fed is signaling that borrowing costs will rise, one might expect that the Fed’s forecast of where it sees rates in the long run.

It would not suggest that the Fed still sees sky-high inflation as ‘unsustainable’ after all, albeit as a result of punishing interest rate hikes and longer than previously expected.

In other words, a pivot is indeed coming, even if not as soon as the markets had hoped this summer.

Joe Lavorgna, managing director at SMBC Nikko Securities and a former White House economic adviser, is one of the few analysts who thinks the Fed will be forced to go U next year because of the economic damage the historic tightening will do.

“The Fed always makes it too high, so when it happens, as it always does, no one sees it, it happens really suddenly, and everyone is caught off guard,” says Lavorgna. “They will go earlier. I can see the Fed reversing course six or seven months from now.”

Markets are not priced like that at the moment. Two weeks ago, rate markets were pricing in 50 bps of easing between March 2023, when the ‘terminal’ rate is expected to be reached, and December. That has been reduced to around 15 bps.

Markets expect about 60 bps of easing between March 2023 and December 2024, the smallest amount since June and almost half of what was priced in just a few weeks ago.


The Fed’s target policy rate is now 3.00%-3.25%, the highest since 2008, and the Fed’s latest projections show it rising to a range of 4.25%-4.50% by the end of this year and ending 2023 at 4.50% -4.75%.

Their projections also included a higher median forecast for 2024 of 3.875% and an initial 2025 expectation of 2.875%. But the median ‘longer’ forecast remained at 2.50%, unchanged from June. In fact, the average longer term expectation has been above 2.50% in all but one set of quarterly forecasts since June 2019, a 2.375% call in March this year.

There is no consensus among economists regarding the so-called ‘neutral’ rate. Lavorgna points out that it might not even be as high as 2.5% because structural rigidities such as a relatively high tax burden, a heavy debt burden and low productivity suggest that potential economic growth is low.

But others argue that structural changes are underway that will keep inflationary pressure higher than before, meaning the neutral rate should also be higher. They include slowing global trade, funding, higher energy costs, and the costs of combating climate change.

Steven Englander, head of FX strategy at Standard Chartered, suggests that the neutral rate is perhaps 3.00%, possibly even higher.

The neutral rate is impossible to determine and is constantly changing, but it is a cornerstone on which portfolio managers make long-term investment decisions. So it is important.

A Piper Sandler survey published on the day of the Fed’s policy decision showed that its clients on the internet expect about 100 bps of easing over 2024, and are collectively about a lower ‘r*’ rate of 25 bps compared to the 50 bps implied by the Fed’s median forecasts. .

Ellie Henderson, an economist at Investec in London, believes that the Fed is underestimating the impact of rate hikes on the economy and inflation.

“We think this will give the Fed an opportunity to stop tightening policy at the end of this year and cut rates to support the economy by the end of next year,” she says.

(The views expressed here are those of the author, a columnist for Reuters)

Related columns:

Funds pivot watched as Fed halves (September 25)

Super peak rises’, even if they’re not peak rates (September 9)

(By Jamie McGeever; Editing by Andrea Ricci)

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