A Perspective On Interest Rate Neutrality

The Federal Reserve (Fed) has been raising short-term interest rates from near zero during 2022 with the guidance that more hikes are coming.  Should we call this a “tightening” of monetary policy?   No, not really, at least not yet.  A better description would be a withdrawal of accommodation.  Semantics can matter in life and economics.

Figure 1: U.S. federal fund futures are on the move

Critical to this discussion is the idea of a “neutral” federal funds rate policy.  The neutral rate is a very “slippery” concept.  The neutral rate is thought to mean that interest rate policy is neither accommodative nor restrictive to growth.  That is, a neutral rate policy is more like a steady-state policy designed to allow the economy to function without policy pushing the economy in either direction, at least until an unexpected event alters the course of the economy into an inflationary path or recessionary situation that is deemed to require a policy response.

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So, what is the neutral rate of short-term interest rates?  The neutral rate is thought to depend on how the federal funds rate compares with longer-term inflation expectations.  Short-term interest rates well below longer-term inflation expectations would generally be considered accommodative, while rates well above inflation expectation would be considered restrictive.  A neutral rate probably also includes a small risk premium for inflation uncertainty.  In any case, the neutral rate policy is in the middle ground, which might be relatively wide, given the lack of specificity in measuring inflation expectations and assessing an appropriate risk premium.

That is, another slippery slope comes with how to evaluate longer-term inflation expectations.  Inflation expectations are not easy to calibrate, especially when the inflation environment is undergoing  significant change.  Economists typically argue that inflation expectations adjust with a lag to changes in the inflation environment.  This view is controversial, since market participants might also adjust expectations based on new information, such as key government policy shifts or major economic events that might include energy market disruptions, among other possibilities.

Figure 2: Long-Term Inflation Expectations

Nevertheless, using a lagged historical data process that weights current information a little more heavily than further in the past information (i.e., a lagged exponential decay), then the change in the inflation environment in the second half of 2021 and into 2022 more than likely lifted long-term inflation expectations compared to the relative stability of core inflation (excluding food and energy) from 1994 through 2020.  From 1994 through 2020, long-term inflation expectations by this method appeared to be closely anchored around 2%.  The surge in inflation in the latter half of 2021 and through 2022 may have increased inflation expectations into the 3% territory. 

Based on this analysis of inflation expectations and adding perhaps 0.5% for inflation uncertainty premium, pushing the federal funds into the 3% territory takes interest rate policy out of the accommodative state into neutral territory.  The neutral territory was last seen pre-pandemic back in 2018 when the Fed was raising rates with the intention of moving out of accommodation and into neutral territory.  The effort was short-circuited by the pandemic of 2020, to which the Fed responded by cutting rates and heading back into an accommodative state.

Figure 3: Accommodative, Neutral, or Restrictive Interest Rate Policy States

Now for the semantics.  Importantly, as discussed, a neutral interest-rate policy would typically mean that policy is neither accommodative nor restrictive.  By analogy, the Fed is taking its foot off the accelerator, but it has not yet to hit the brakes.  What we have witnessed in 2022 is best described as a withdrawal of accommodation. By this interpretation, the Fed has not yet embarked on a “tight” or restrictive interest rate policy. Recession risks materially rise only when the Fed hits the brakes, raises short-term rates well above both inflation expectations and long-term U.S. Treasury yields, resulting in an inverted yield curve between the federal funds overnight rate and Treasury 10-year Note yields.  While the Fed may decide in 2023 to hit the brakes, the Fed has not yet taken that step, only time will tell, as the Fed is highly data dependent and considerable new information will arrive between September 2022 and early 2023.

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