What the Fed’s obsession with “neutrality” means for markets, rates, and your portfolio.
KEY TAKEAWAYS
The Fed’s concept of neutrality is central to current policy debates
R-star is the theoretical neutral real interest rate–but nobody knows its true level
The Taylor Rule adjusts neutral rates for inflation and the output gap
GDP revisions and inflation prints push the implied policy rate higher
Markets may be misaligned, still expecting cuts even as math suggests tighter policy
MY HOT TAKES
Neutrality is more of a story than a science
The Fed is basically driving blind with r-star
The Taylor Rule may be simple math, but it drives real policy debate
Markets may have priced in cuts too early, ignoring the math
Consumers remain the wild card, keeping the economy hotter than expected
You can quote me: “Yesterday’s GDP revision means the Fed might already be below neutral.”
It’s all about the base. I cheated with that tagline which is supposed to be about the bass not “base”, but alas, this note is not about entertainment, but rather, all things finance, markets, and economics… AND some other random things that seep in from time to time. Today, I want to talk a bit more about Fed interest rate policy. I know, I know, this story feels like it’s getting a bit old, but it is still one of the principal drivers of markets these days.
This morning–WHILE YOU SLEPT– I was on CNBC’s Worldwide Exchange with my friend and host Dominic Chu. That last block of the show always features a word of the day, and I have come up with some good ones in the past–one even went viral. 🤣 This morning, the word I chose was “Neutrality.” I chose it because it has very much been at the core of all the recent Fed-speak we have been treated to.
It’s a favorite of the Fed Head himself. Neutrality is like the Fed’s sweet spot–where policy rates are neither juicing the economy nor strangling it. It’s the point where policy is considered balanced, allowing growth to run at potential without stoking inflation. The problem is nobody actually knows where that number sits, not even the Fed. That leaves it as a great source for debate amongst not just Fed policymakers but us normies that have to make portfolio decisions based on what the FOMC decides… which is supposedly based on where rates are relative to that "neutral" rate.
Think about it like this. You are driving THE SPEED LIMIT on a highway, and you take your foot off the gas completely. Your car is now moving forward on momentum alone. There are forces that will immediately slow your pace like friction and aerodynamics. If you slow too much you might press on the accelerator a bit to keep moving at pace. You may come to a downhill, and your car may accelerate while your foot is off the gas. In order to avoid crashing into the car in front of you, you may have to apply your brakes, but only subtly, because you don’t want to stop and risk getting hit by the car behind. You may see traffic in the distance and decide to slow your pace early in order to avoid getting whiplash to avoid a collision, but still, you must not slow too much, too early and cause traffic yourself.
It sounds complex, but we do this subconsciously every day on the roads, and the Fed is responsible for doing a very similar task with the US economy. No stress, right? 😰 The Fed Funds rate is that brake/gas pedal combination, slowing the economy if it is getting too fast and causing inflation or prodding it when employment slows and threatens to cause a recession. But I am sure that I don’t have to tell you the economy is far more complex than an automobile. The response time to changes is slow, and the feedback loop is really long. Sometimes, it’s not even clear if the changes in control are working.
The Fed thinks of it like this. There is a policy rate that is neutral at which the economy can run at its full potential without making any changes. It is obviously based on some mystical “neutral” rate. That is referred to as r*, or “r-star.” R-star is technically a real neutral rate which factors in inflation. We know what inflation is, give or take, so if we just add it to the r-star we know where Fed Funds should be if the Fed thinks that the economy is in good shape. But as I said earlier, there are some problems… er, challenges. You see, nobody knows what r-star is! Well, there are some interesting theoretical models that guess what it should be based on historical data. Ok, let’s assume that the Fed starts with the output of those models. Now the problem becomes, what to do about policy. Is the economy running its full potential without stoking inflation? If not, the Fed must apply the gas. Is the economy running hot and causing inflation to run up? If so, the Fed must apply the brakes. How can we even assess those to determine whether rates should be higher or lower than that elusive r-star. For that, the Fed leans on the Taylor Rule which I covered in a blogpost/newsletter earlier this week. I want to go back to it briefly, because it is so timely. To refresh your memory, here is the Taylor Rule formula.
i = r∗ + π + 0.5(π - π∗) + 0.5(y - y∗)
Where:
i = policy rate
r∗ = the neutral real interest rate
π = current inflation
π∗ = inflation target (2%)
(y - y∗) = output gap (how much actual GDP is above or below potential)
The Fed uses the Taylor Rule as a benchmark guide to determine rate policy. You can see how it starts with nominal neutral rate: r∗ - π and then adjusts it based on how far inflation is off from the Fed’s target (π - π∗) and how much the economy is performing over or under potential (y - y∗). If the inflation is far above target, you add to the neutral rate. Similarly, if the economy is running far above its potential, you also add to the neutral rate. Hot inflation, hot economy, higher rate policy. It’s just math, silly!
Now let’s take a step back. Does the Fed do exactly as the model suggests? No, it is merely a benchmark, but it is a very important benchmark, because all of the FOMC members consult it. The model is constantly being run and re-rerun. “Wait, why constantly,” you may ask. Because all those fancy variables in the equation are constantly changing! All except for maybe π∗, which is the Fed’s 2% inflation target. Knowing that, you know that the Fed’s target–the bullseye–is constantly shifting.
So, why am I bringing this up on a Friday after I already covered the topic on Wednesday? Because, yesterday, we got a really hot upward revision in GDP. Annualized Quarterly GDP was revised up by +0.5% to 3.8%. Folks, that is a rare and large upward revision. The reason for the boost was… wait for it… wait for it… none other than my favorite topic: consumption. God bless you, American consumers, you sure know how to throw a party.
In any case the upward revision is really good news for the economy, and it should make you feel good. But does it make the Fed feel good? Of course it does! Who doesn’t want a strong economy? If you have been following along, you would probably imagine that just minutes after the release yesterday morning, economists in windowless offices at regional Fed banks and Fed HQ put down their egg sandwiches and fired up their dated, government-issued computers to re-run their Taylor Rule calculations. What changed? Well, it is quite likely the y in the output gap went up as well as the r∗. Do you know what that does to the i–the target policy rate? It goes up–just math, silly. If the target rate is higher than the current Fed Funds Rate, it would be considered accommodative and would require policy to be moved up. In other words, it's not neutral. The bigger implication is that when Powell talks about normalization of rates, he is implying that policy should be lowered from current levels to get to that neutral level. It is possible that we are not above it, not at it, but already below it!
Clearly, those Fed economists were not the only ones running their Taylor models yesterday morning. Fed Funds Futures rose, implying lower probabilities for 2 rate cuts between now and the end of the year. 2-year Treasury Note yields also gained in response.
This morning, we will get PCE Inflation which is the Fed’s preferred inflation gauge. It is expected to tick up to 2.7% from 2.6%. That gets plugged into the equation above (π), and wouldn’t you know it, an increase in inflation raises the target rate. It’s just more math, silly. If you use core inflation, that is expected to come in at 2.9%, unchanged from last month. The good news is that the Fed uses core inflation, so if the number comes in as expected, the economists may be able to have a lazy Friday morning.
Ok, ok, before you panic and wonder if the market will have a temper tantrum because it may not get the rate cuts it needs…er, wants, I will leave you with one final thought. It is getting cooler here in New York. Each morning, I have to decide on whether or not to wear a coat. When I make that decision, would I use today’s weather forecast or even yesterday’s actual weather. I certainly wouldn’t use the actual weather from last May. That would be silly. Similarly, I want you to bear in mind that yesterday's GDP revision was to Q2 GDP, which ended on May 31st. Now, I don’t want you to ignore the hot print, but rather, put it in perspective. Directionally, it is a strong sign for the economy, but it is not likely that the Fed would decide to hike rates based on data from last May. Still, FOMC members can’t ignore it either.
So, the Fed continues on its never-ending quest to find the neutral rate and adjust rates “appropriately” to get there. The job is the same, though the base rate is on the move. Pump up the bass!
YESTERDAY’S MARKETS
Stocks traded off yesterday in response to a strong GDP revision clouding the Fed’s rate cut path. Bond yields climbed and the curve steepened, spurred on by sharper rises in shorter-termed yields.
NEXT UP
Personal Income (August) is expected to have climbed by 0.3%, slightly slower than the 0.4% gains in July.
Personal Spending (August) may have climbed by 0.5% for a second straight month–and surprised… no one. Crazy consumers. 🤪
University of Michigan Sentiment (September) will probably come in unchanged from its earlier estimate.
Next week, we will get more housing numbers, JOLTS Job Openings, Consumer Confidence, ISM Manufacturing, Durable Goods Orders, flash PMIs, and the monthly employment numbers from BLS. Also, next week, we will approach the government’s deadline to negotiate a budget–it’s getting to the wire, and it will certainly start to put markets on edge if not resolved. Come on back on Monday and download a weekly economic calendar, so you can be reading the same music as the Fed.
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