- The idea of low neutral funds rate has surprising currency, but could erode with more evidence of solid growth.
- We believe incoming information suggests the neutral funds rate would be moving higher, not lower.
- We see neutral funds rate at 3.75-4.00%, which implies an overvalued Treasury market.
The hottest topic in the bond market at the moment is the idea that the “neutral funds rate”—where the Fed will rest short-term interest rates when the economy returns to normal—has declined to historically low levels. A low neutral funds rate would imply gentler rate hikes, a lower yield curve and possibly other effects across markets. We’re big believers in the neutral funds rate, and it’s an important input into our views on monetary policy and rate valuation. But we’re puzzled why the idea of a depressed neutral rate caught hold more recently. If anything, incoming information suggests the neutral funds rate would be moving higher, not lower.
There are two distinct (but often conflated) ideas for why the neutral funds rate has come down: (1) lower potential growth, and (2) headwinds driving a wedge between risk-free rates and broader financial/economic conditions. Activity data strongly suggest that potential growth increased at a slow pace over the last five years—which economic theory says should translate into a lower neutral funds rate. On average, GDP growth has increased only about 2.25% recovery-to-date, and yet measures of slack have improved substantially. Thus, trend growth must have been well-below historical norms. Our modelling suggests potential growth may have been as low as 1% in recent years (Figure 1).
Figure 1: Implied potential GDP growth
We also have sympathy for the idea that “headwinds”—essentially, scars from the recession and financial crisis—drove a wedge between the funds rate and broader financial/economic conditions (for more detail see here). A popular model created by San Francisco Fed president John Williams and coauthor Thomas Laubach says the short-run equilibrium funds rate (a cousin of the neutral funds rate) has hovered around zero for the last few years (Figure 2).
Figure 2: Laubach-Williams estimate of short-run equilibrium funds rate
That being said, we are concerned that the supporting evidence for both of these points is too backward-looking. Potential growth has been low, but that need not last forever. Based on history, trend growth of 1% is very unusual for an economy with current U.S. demographics. Likewise, many of the headwinds that have depressed the Laubach-Williams estimate—fiscal tightening, household deleveraging, the European financial crisis—are temporary in nature. The model’s estimate of the equilibrium funds rate will move back up as these headwinds fade.
Recent news is encouraging on both fronts. Although still tentative, recent data hint that the labor force participation rate may have stabilized. And while it is very unlikely to rebound, important recent drivers like disability and school enrollment should not lead to continued declines in the future. Headwinds of various types also seem to be abating (e.g. better global growth and household credit trends). All these changes would tend to push up the neutral funds rate in standard models.
So where is the neutral funds rate today? We approach this question in a few ways, but the following rule-of-thumb works pretty well across countries and over time:
Neutral policy rate = population growth + real per capita GDP growth + inflation target - “a little bit”
For the U.S., most demographers expect population growth of around 0.75% per year. Prospective real GDP growth is of course more controversial (it’s frankly the heart of the matter). But a reasonable starting assumption is that growth will look more “normal” in the years ahead—not as fast as the credit boom years but not as slow as the deleveraging years. For industrialized economies, real per capita GDP growth has averaged about 1.5% for the last 200 years, and we take this as our guesstimate of “normal”. We also need to subtract “a little bit” (for technical reasons) and add inflation. For G10 economies the “little bit” is usually around 0.25-0.50%, and the Fed’s inflation target is 2%. Putting the pieces together, we arrive at 3.75-4.00% for the neutral fund rate (3.75-4.00% = 0.75% + 1.5% + 2.00% - 0.25-0.50%). This estimate is below pre-crisis consensus estimates of around 4.5% but much higher than levels some investors are banking on today.
If the neutral funds rate is indeed 3.75-4.00%, long-term Treasury yields are too low (Figure 3). We are doubtful that ivory tower arguments will change anyone’s mind on their own. But the low neutral rate idea has surprising currency given its thin theoretical and empirical basis, and we would not be surprised to see it ditched with a bit more evidence of solid growth.
Figure 3: Neutral funds rate and 5y5y Treasury yield