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The Pursuit of r*

September 2, 2019

Last Week This Morning

  • 10 Year Treasury fell to 1.50%, at one point hitting its lowest level in three years
    • This represents one of the single most volatile months in history
    • German bund drifted lower to -0.71%
    • Japan 10yr also moved lower to -0.28%
  • 2 Year Treasury fell slightly to close at 1.51%
  • LIBOR at 2.09% and SOFR at 2.12%
  • Yield curve inverted as much as 5bps
  • Core PCE came in at 1.6%, well below the Fed’s targeted 2.0%
  • Q2 GDP was revised lower to 2.0% from 2.1%
  • Durable Goods came in stronger than expected, 2.1% vs 1.8% forecasted
  • Home prices rose at a slower clip, up 2.1% vs 2.4% last month
  • England is moving swiftly towards a no-deal Brexit
  • Chinese Ministry of Commerce spokesperson Gao Feng indicated China would not retaliate to the latest increase to tariffs
  • Univ of Michigan Confidence index dropped to its lowest level in three years
  • The market has odds of a rate cut at the September 17th FOMC meeting at 100%
  • ECB is likely to cut rates at its own meeting on September 12th



Neutral interest rate is perhaps the holy grail of monetary policy.  The neutral rate, or r*, is the rate that neither encourages nor discourages growth.  Equilibrium.  It’s also a hypothetical.  And it’s not static – it changes constantly.

At the October 2018 rate hike, the FOMC removed the use of the word accommodative to describe monetary policy.  The Fed had just hiked to 2.0%-2.25%, the same level as today.  By removing the word accommodative, the Fed was acknowledging it was moving towards neutral rate.  Accommodative would be below neutral, restrictive would be above neutral, etc.  At the time, the Fed intended to hike beyond neutral because things were going so well.

We spent considerable time in 2018 discussing how the Fed had indicated it believed neutral to be around 2.50%.  Every single hike beyond that would restrict growth, with each hike becoming successively more challenging.  So, while Powell & Co were calling for 3.25%-3.50% as the final landing spot, we were skeptical.

The FOMC stalled out at 2.50% and now is reversing course.  How quickly and aggressively the Fed cuts may dictate whether we avoid a recession.  With two dissents that opposed a rate cut at the last FOMC meeting, there remains considerable risk the Fed is reacting too slowly to avoid a downturn caused by monetary policy.

Fortunately, NY Fed President John Williams is actually one of the leading academic scholars on the theory of a neutral rate.  In fact, the primary r* model is called the Laubach-Williams Estimate.  He’s the Williams in that name.  It would be like having a Conklin Cynical Sarcastic Model.

Here’s that graph illustrating the projected neutral rate from 1960 through 4/1/19.

Source: NY Federal Reserve

The most recent update to the model was in April, so the data is a tad stale.  But as you can see, Williams’ own model suggests neutral rate was 0.83% in April.  To be clear, that is the real rate, meaning it is adjusted for inflation.  If inflation is 2.00%, then Fed Funds should be at 2.83% to be considered “neutral” (0.83% + 2.00%).

But inflation wasn’t 2.00%, it was 1.6%. That put the hypothetical neutral rate closer to 2.40%.  Since Fed Funds was 2.25% – 2.50%, I can’t blame for the Fed feeling like it was in the right ballpark.

But this is from April, and I think we can agree conditions aren’t better than they were in April.  Conditions have likely deteriorated, and at a minimum the risks have increased even if the underlying data isn’t materially weaker.

If I was a Fed member using this r* model as a guideline, I would have felt like we had set FF in the appropriate range.  This is an imperfect science after all.  But one very consistent message from nearly every Fed official not named Kashkari has been the expectation that inflation would return to its long run target of 2.0%.  In fact, the Fed was so optimistic that it indicated it would be comfortable allowing inflation to overshoot for a short period to compensate for ZIRP.

Given that belief, I think they were making decisions/statements based on an expectation for inflation to push higher.  The Fed’s erroneous belief that inflation has to return to 2.0% (or higher) caused them to raise rates too high preemptively.  They looked at that graph above and said, “So, 2.40% is neutral, but once inflation returns like I expect it to, Fed Funds will need to go to 2.75%.  And then, if I think we need to allow for an overshoot, we probably need to raise rates above 3.0%”.

Just like most of us, they have been looking around and saying, “things feel good and inflation will eventually return, so let’s be responsible and raise rates while we can.”

But then inflation failed to materialize, just like it has for the last ten years.

They are incorporating rising inflation expectations into their decision-making process, when in fact they should be factoring in flat or falling inflation expectations.

This is why the market is fearful the Fed won’t intervene aggressively enough.  They will continue to overestimate inflation and therefore be reluctant to cut rates materially.

In all likelihood, as the Fed cuts rates we are transitioning quickly from neutral-ish to accommodative.  But with Fed officials clinging to lagging indicators (like the unemployment rate) as reasons to reduce rates slowly, it may be too slow.

The Fed’s views on and pursuit of r* may dictate whether or not the economic expansion continues into 2020 and beyond.

Either the market is overreacting or the Fed is underreacting.  Until that disparity resolves itself, 10yr Treasury rates will struggle to move higher.

Here are current market-implied 10 Year Treasury yields at year end.

Y/E 2019             1.56%

Y/E 2020             1.57%

Y/E 2021             1.63%

It doesn’t get much more benign than that.


This Week

Friday’s job report is the headliner, but there’s also some manufacturing data along the way.

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Click to Open: The Pensford Letter PDF