OPINION:
The Federal Reserve’s decision to cut interest rates moved markets. The next day, major stock indexes surged to record highs.
It’s natural for investors to speculate how much lower the Fed will take rates over the next several months, and that sends economists stargazing.
We ask what the neutral real rate of interest is, which we affectionately call r-star (r*).
As inflation ends its descent, the Fed should strive to set the federal funds rate at a balance between being neither too low, which would encourage excessive spending and inflation, nor too high, which would discourage adequate investment and economic growth.
The Fed’s 2% inflation target is somewhat arbitrary, and the central bank may settle for something a bit higher if that accomplishes price stability. That occurs when expected inflation is low enough not to appreciably alter household or business decisions.
Consumers don’t rush to spend today to avoid higher prices tomorrow, and businesses aren’t reluctant to invest because falling prices in times of slack demand would make loans difficult to service.
According to the consensus of Fed policymakers’ projections, inflation should ultimately settle at 2.0% and the federal funds rate at 2.9%.
That would put r* at 0.9%.
The end point for the federal funds rate would not leave much room for policymakers to cut interest rates when the next economic crisis comes. During easing cycles from the 1960s until COVID-19, the Fed cut rates an average of about 5.3 percentage points.
Indeed, the Fed’s notions and econometric estimates of where the federal funds rate should settle have been falling for decades.
Many factors determine the natural rate.
Potential economic growth depends on productivity and labor force growth. Higher potential growth would encourage more entrepreneurial risk-taking, increase business investment and boost r*.
If interest rates are set too low, businesses will over-invest and accelerate inflation, and households will not save enough to finance investment and government deficits.
If risk-averse households pile into safe assets such as Treasurys and CDs, this will drive up the pool available for savings no matter the rate of return and drive down r*.
Declining birth rates have reduced indigenous labor force growth in recent years, lowering potential growth and r*. Longer life expectancies and potential working lives have increased both the savings needed to fund retirements and the capacity to lay those up, also lowering r*.
As we emerge from COVID-19, several factors are coalescing to raise r*, and the Fed may be overestimating how low r* may be and how far down it can push the federal funds rate without causing aggregate demand to exceed supply and accelerating inflation.
The advent of artificial intelligence is greatly increasing the demand for capital. Prodigious sums are being spent on processors, servers, data centers and the electrical grid, and all this should considerably boost productivity growth.
After the 2007-2009 global financial crisis, households burned by too much speculation became risk-averse and needed to deleverage (rebuild their balance sheets after taking big losses).
We were emerging from that when COVID-19 hit, and these days, investors are expressing enthusiasm for riskier investments — in particular, stocks and, among wealthy investors, private credit funds.
In recent years, the surge in immigration has boosted labor force growth and potential gross domestic product above what would have been permitted by indigenous population growth and the immigration regime enforced under former President Donald Trump.
This surge in new entrants will increase potential monthly employment growth from about 80,000 to 180,000 in 2024. With the economy adding 180,000 jobs a month so far this year, the surge has raised both economic growth and r*.
In addition, the federal deficit is now 7% of GDP, the highest it’s been in peacetime other than during the financial crisis and COVID shutdowns — even higher than during the Great Depression and peak New Deal spending. This taxes the pool of savings and raises r*.
Econometric models that estimate r*, such as those maintained and continuously updated by the New York Federal Reserve Bank, currently put r* at about 1%. But they can’t capture all these complex changes in real time.
Independent policy economists are putting r*, as it applies to the federal funds rate policy, closer to 2%.
Splitting the difference puts r* at about 1.5%. Assuming a rate of inflation between 2% and 2.5% places the end point for a federal funds rate that neither encourages inflation nor stifles growth between 3.5% and 4.0%
Fed Chairman Jerome Powell is inclined to look past estimates of r* and, as data comes in, try to balance “the risk of tightening monetary policy too much against the risk of tightening too little.” He may find the federal funds rate he can tolerate to be appreciably higher than 2.9%.
• Peter Morici is an economist and emeritus business professor at the University of Maryland and a national columnist.
Please read our comment policy before commenting.