Federal Reserve Chair Jerome Powell on Friday removed all doubt that interest rate cuts are just around the corner. “The time has come for policy to adjust,” he said at his much-hyped annual speech in Jackson Hole, Wyoming, setting off a knee-jerk rally in stocks and bonds. Inflation risks have receded while labor market risks have increased, he added, and the central bank wouldn’t “seek or welcome further cooling in labor market conditions.” All of this points to a series of policy rate reductions in the coming quarters.
But before Powell even approached the podium, the market was expecting about 2.25 percentage points worth of easing to take the fed funds rate to around 3%-3.25%. The Fed won’t push markets much further simply by validating those expectations. If longer-term borrowing costs are to continue declining, it will have to come from a reassessment of the Fed’s ultimate destination.
Longer-term rate expectations stem from a highly academic debate of the neutral rate of interest, or r-star — the rate that should prevail in an environment of maximum employment and low and stable inflation. In essence, the neutral rate is that which neither fans nor restrains economic activity.
Up until recently, markets and policymakers largely thought that the long-run neutral rate was around 2.5% (or 0.5% “real,” adjusting for inflation at 2%). Even when the economy showed surprising resilience in the face of rate increases in 2022 and 2023, it took years to dislodge those beliefs. According to the Federal Reserve Bank of New York’s Survey of Primary Dealers, median long-run rate expectations only started rising meaningfully around October of 2023 and have since increased to around 3.1%. Now, it’s reasonable to ask if they might retreat. But even if they do, it will take time.
So what does that say about fixed-income markets?
At the time of writing, yields on 10-year Treasury notes — which partially reflect the market’s guess at where neutral is, plus a term premium and some other near-term factors — sit around 3.80%. If you assume that the fed funds rate will be between 3% and 3.25% for most of the term of the bond, there really isn’t room for the yield on the 10-year note to move much lower. That would take a meaningful reassessment of neutral.
Notably, the long-run views of primary dealers finally stopped moving higher in the July survey. They should drift very subtly lower again in coming months as payrolls revisions and the recent uptick in the unemployment rate paint a slightly different picture of just how resilient the economy has been to rate hikes.
The precise location of neutral is thought to derive from forces including demographics and productivity. Unfortunately, it’s impossible to estimate neutral in real-time with a high degree of confidence, as Powell himself has noted in previous Jackson Hole lectures. In 2018, he said that “the location of the stars have been changing significantly.” In 2023, he used similar language: “As is often the case, we are navigating by the stars under cloudy skies.” In practice, policymakers try to feel their way to neutral by moving slowly.
The New York Fed’s John Williams, one of the most famous academic r-star gazers, is skeptical that there’s indeed been a sizable move up in the long-run “neutral” rate, and I’m sympathetic to that view. Many American households and businesses locked in ultra-low interest rates and amassed large cash hoards during the pandemic, which made them seem initially insensitive to the monetary policy medicine. Excess savings won’t last forever, nor will the mortgage lock-in effect. What’s more, recent preliminary revisions to the US payrolls data show that the labor market wasn’t actually as strong as we all thought in 2023 and early 2024.
There's no question that Powell's remarks on Friday were dovish. In addition to talking up labor market risks, he also suggested that well-anchored inflation expectations were working as a sort of self-fulfilling prophecy. Though central bankers had worried that the recent experience could dislodge them, he seemed to think that expectations had passed their biggest stress test with flying colors.
But it may not matter what the experts and pundits say at this point; the changing perceptions about neutral will be hard to undo. Policymakers will ultimately find their way to r-star ploddingly and empirically, meaning it could take years for the debate to be settled.
As the Fed’s benchmark rate reaches 3%-3.25% in 2025, policymakers will probably pause to see how the economy responds. If inflation seems controlled and the labor market is uninspiring, they may make another surgical cut in 2026 — and then perhaps another one down the line. Even if the r-star doves are right, estimates of neutral may not fully return to 2.5% until 2027 or 2028. That means that the rally in Treasury notes may soon hit a wall.
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