The US Federal Reserve has chosen a ‘sprint first, then dawdle’ approach to rates normalisation. Dawdling makes sense given the neutral rate is uncertain and probably higher than pre-pandemic.
The US Federal Reserve has started its cutting cycle with an outsized 50 basis point move. This was larger than what we had expected, though the direction and timing was obvious. Starting with 50 basis points is what you do when you want to get to where you need to go as soon as you reasonably can. The counterargument to this approach is that you might not want to risk scaring the horses with an outsized move that hints you think something is seriously wrong with the US economy. These are matters of judgement. Not all the FOMC members were persuaded, with Michelle Bowman dissenting.
The former central banker in me expected that Fed policymakers would not want to risk another episode of market volatility and economic catastrophising like the one seen a few months ago, and so would choose the more conservative approach. It turns out that you can word up key people in the media to soften the surprise factor. (This is another thing that does not sit well in the Australian context, where a media leak would be a conduct issue.)
For the record, the Fed’s outsized cut has no implications for the RBA’s decision next week or at subsequent meetings. As we have noted in the past, because Australia has a floating exchange rate, the RBA can set monetary policy here according to domestic circumstances. We continue to expect the RBA to hold rates next week and for the rest of the year.
Sprint first, then dawdle
The Federal Reserve does not need to be in a hurry. The US economy is not slowing precipitously, and growth in US real consumer spending remains robust. Indeed, the median FOMC member only expects to cut a further 50 basis points over the next two meetings, and a notable fraction of members expect only 25 basis points.
Central banks are characterising their rate cutting cycles as normalisation cycles. Policy had needed to be tight to address the high inflation stemming from the pandemic supply shocks and the policy-related demand shock that occurred in response to the pandemic. Now that inflation is close to target in many economies, policy does not need to be as tight as it was. And as we have explained before, because policy works with a lag, central banks need to start normalising before inflation is all the way back to target.
If the objective is to normalise, typically that would call for a measured initial response. By moving more quickly initially, the Federal Reserve has broken the mould to an extent. And they took this approach despite the exuberant equity market and other measures that suggest US financial conditions are not that tight. The FOMC members have also taken this approach to the early phase of the rate-cutting cycle even though the ‘dot plots’ that accompanied the announcement suggest the Fed funds rate will not return to neutral levels until 2026.
This ‘sprint first, then dawdle’ implied future path for the US can be reconciled by the considerable uncertainty implied by the members’ projections for the long-run level of the Fed funds rate, a proxy for their view of neutral. If you know exactly how far you need to go, you can get there quickly. But if you are unsure of your destination, tread more carefully. A rapid reversion to a level still a bit above neutral and slow from there makes sense in that situation. It is also consistent with our existing expectations that the pace of decline in the Fed funds rate would be faster in the first six months of the cycle than the second.
Many forces are lifting neutral
The FOMC’s uncertainty about the level of the neutral policy rate is warranted, more to the upside than down. Their latest forecasts upgraded their estimate, but it is not clear if they have gone far enough; the methods central banks use to estimate neutral policy rates are inherently incremental. A deeper look at underlying developments suggests that there are a range of global factors pushing in the direction of the global rate structure being higher than it was in the period between the Global Financial Crisis and the pandemic.
Among these factors are the geopolitical and sociological forces that are pushing towards larger public sectors in advanced economies. The IMF has recently noted political support coalescing behind greater government spending. The root causes are multifaceted. Geopolitics is now more multipolar, with the United States and China treating each other as strategic rivals rather than purely as trade partners. This pushes governments to boost spending on defence and national security, as well as expanding strategic manufacturing capability. Population ageing is also necessitating more health-related spending. Governments are also heavily involved in investing in the energy transition, along with the private sector.
More broadly, we see a sociological shift towards greater demand for – or at least tolerance of – government intervention in the economy to forestall risks and harms that sections of the community perceive. The pandemic may have amplified that shift. In Australia, at least, higher public demand and taxation have become a trend in recent years.
The balance of investment and saving in the private sector has also tilted towards more investment. Like governments, the private sector needs to execute on the energy transition, adopt energy-intensive innovations in AI and adapt to changing patterns of trade. There also might be more scope to fund investment, noting that the global banking sector is no longer in the mode of building up capital to meet new Basel requirements, as it was in the period between the GFC and the pandemic.
All these forces mean that investment demand is stronger relative to the past. While the Asian region remains an important source of saving, it is not an even bigger source than it was during the period of the so-called ‘global savings glut’. The net is therefore likely to be a tilt towards investment relative to saving. The way that the demand for and supply of funding for investment equilibrates is through a higher structure of global interest rates. This implies a higher risk-free ‘neutral’ rate. It might also have implications for things like average term premia and risk premia.
There are some forces pushing in the other direction. For example, global goods inflation is likely to remain low given weak domestic demand in China and the approach the authorities there are taking to growth and development, principally by boosting manufacturing supply capacity. The additional investment involved would tend to boost the global neutral real rate. However, the disinflationary impact means that actual nominal rates could be lower than otherwise, even if neutral rates are not.
Also working in this direction, population ageing is tending to boost participation and labour supply rather than reduce it in most western economies – though not the United States; we saw more evidence of this in the rising trend in participation here in Australia this week. As well as being disinflationary, abundant labour supply relative to population means less incentive to invest in labour-saving technologies. This is not so great for global productivity but could help offset increases in investment demand from other sources.
At this stage, though, we think the net of all these forces takes the global structure of interest rates higher than it was pre-pandemic. Indeed, we think neutral rates are more likely to in the low to mid 3% range than the high 2% level implied by the Federal Reserve’s current projections.
