What will "new neutral" rate be?

April 1, 2015 08:58 AM

If there ever was an economic concept that currently is not a layup, it would be what the future average level of Fed Funds will be. No one really knows and unlike the gimme layup that Coach K provided for me, there are no “gimmes” when it comes to scoring a Fed Funds basket. As we all know, the neutral or natural rate of interest is not a new concept. Irving Fisher back in early 20th century hypothesized that while neutral nominal policy rates could go up or down depending on inflation and cyclical growth rates, that the real natural rate of interest was relatively constant. I think history has disproved this thesis, not only because central banks and government fiscal policies have suppressed (and sometimes elevated) that real rate but because of structural changes in real GDP growth rates, demographics, and the globalization of finance amongst others. Greenspan hinted at that with the “irrational exuberance” question that he never answered, and Bernanke got closer with his “global savings glut” but neither of them – nor Janet Yellen and her thousands of historically model driven staff have come very close since. They still believe in their 3.75% nominal blue dots which conflate to a 1.75% real rate of interest that has been in vogue for 30 years now.

Yellen herself has admitted that the real neutral rate changes and that it depends on a variety of factors including fiscal and monetary policy, term premiums, equity prices and yield curves – so many as to be impossible to model. When Jim Cramer screamed “they know nothing, they know nothing”, he was being a little unfair but not by much. It was a 3% real rate of interest in the U.S. that broke the levered global economy back in 2006/2007; a rate that may have been appropriate 20 years before when credit as a percentage of GDP was 200% instead of 350%, but not in 2006, when the obvious micro example of a 1% short term teaser rate on a $500,000 home in Modesto, California became a Libor + 3% loan shortly thereafter, and broke the back of the U.S. housing market.

Actually a few economists at the Fed have climbed on board the new neutral train, some as early as 2001 when a paper from Janet Yellen’s own San Francisco Fed authored by Thomas Laubach and John Williams showed the history of a changing U.S. real rate of interest from 4.5% in 1965, to which it descended on a smoothing scale to a now (–0.35%). Their model is updated quarterly by the way, and while I’m not a believer in historical models per se, I think it’s obvious that the real neutral has changed dramatically as evidenced by real time prices in the bond market. What the new neutral rate will be for the next 5-10 years is however, still up for grabs and of course is a central question of this Outlook.

Commonsensically, and aside from statistical modeling, it would not be unusual for a new neutral to appear after the devastation of Lehman and The Great Recession. Reinhart and Rogoff in fact have measured dramatically different real policy rates during depressions and subsequent recoveries, acknowledging the obvious, that long periods of financial repression with Treasury yield caps, as well as inflation shattering changes in the global financial system such as Bretton Woods and its eventual transition to the dollar standard in the early 1970’s, had a significant influence. But those policy changes indeed fit into my thesis. Rogoff and Reinhart’s average (–2%) real policy rates in advanced economies from 1940 to 1980 were a function of prior leverage and necessary delevering. Central bankers used policy rates as a hidden weapon until recovery was assured and Jim Grant’s dreaded inflation reappeared in the 1970’s. At that point it was appropriate for Paul Volcker to impose positive real rates – really positive real rates. The real rate, to my way of thinking while difficult to model, can subjectively and commonsensically be assumed to create super debt cycles and asset bubbles, and then attempt to heal them in the aftermath of the popping. Such has been the experience over the past century of central banking in the U.S. and elsewhere.

I am not presenting anything revolutionary here worthy of a Nobel Prize, but reminding you and myself of why the new neutral real rate of interest may be much lower now and in the future than what it was from Volcker 1979 to Bernanke 2009, a number which Rogoff and Reinhart calculate to be +1.35% in advanced economies and +2.88% in emerging economies.

One can approach an estimated value for developed (and emerging) economy new neutrals from another direction. I think it’s informative to measure the spread between policy rates and Nominal GDP growth rates for the post Lehman experience to get a handle on what rate has been necessary to stabilize certain large developed economies over that period of time. The complicating introduction of QE’s around the globe will muddle that observation but only to the benefit of a more conservative conclusion. My commonsensical hypothesis is that nominal policy rates necessarily need to be lower than Nominal GDP. If annual GDP is the return on total outstanding credit and implied equity for a nation’s economy, then the safest and most liquid asset must necessarily be priced lower than GDP in order to induce investment. That would be the policy rate. How much lower however, is the question? Let me summarize by saying that nominal policy rates in the U.S., UK, and Germany have been on average 350 basis points below Nominal GDP growth since 2010 and 150 basis points below inflation. And these numbers are for the three strongest developed economies! In order to stabilize the three developed titans, the real new neutral policy rate in these countries has been (–1.5%) for 5 years. It is not unreasonable to assume it might be 0% instead of the Feds’ 1.75% even if these economies return to “normal”. Other developed and developing economies need to reduce theirs in a similar fashion.

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