Powell wants to bring rates closer to neutral. But what is neutral? Think 5% to 6%, says former top Fed official

As U.S. inflation climbs higher than expected, Fed Chairman Jerome Powell has charted a policy course in which the Fed will move quickly to raise its benchmark interest rate to “a higher level.” neutral” interest rate, and possibly higher. if necessary.

“It is clear that there is a need to act quickly to bring the monetary policy stance back to a more neutral level, and then to move to more restrictive levels if that is what is needed to restore price stability. “Powell said in late March and again a month later.

The aggressive policy trajectory will likely begin with a half percentage point rate hike on Wednesday.

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But what is this neutral rate?

For months, talk has centered on a 2.4% rate, with some Fed officials pointing to that level and the Fed’s quarterly economic forecast pegging the “longer-term” federal funds rate at 2, 4%

But that’s the wrong measure for neutrality, said Andrew Levin, an economics professor at Dartmouth College and a longtime Fed member, including a special adviser role on monetary policy strategy and communications. on the Fed Board between 2010 and 2012. He currently advises the central banks of Norway and Sweden and is also a Visiting Fellow at the International Monetary Fund.

With the base measure of the Fed’s preferred inflation gauge at 5.2%, that means the neutral funds rate is actually in the 5% to 6% range, Levin said, in an interview. .

The 2.4% rate that is often quoted is really just the “neutral” level when inflation turns to the Fed’s inflation target of 2%, he added.

A guiding principle for fighting inflation is actually laid out on the Fed’s website, in a section called “Principles of conduct of monetary policy.

It reads: “The central bank should raise the policy rate, over time, by more than one-to-one in response to a persistent increase in inflation and lower the policy rate by more than one-to-one in response to a persistent decline in inflation. For example, if the inflation rate rises from 2% to 3% and the increase is not caused by temporary factors, the central bank should raise the policy rate by more than one percentage point.

Core PCE inflation rose to an annual rate of 5.2% in March 2% in the same month last year.

Of course, the key is how temporary the recent surge in inflation is and that remains to be seen, although the Fed has already been burned by calling last year’s price increases “transient”.

Powell is expected to say that while there is a lot of uncertainty, the Fed “needs to take a neutral stance, which means we need to move the fed funds rate to roughly in line with, or slightly above the level of inflation”. said Levin.

“If Powell communicated that on Wednesday, I think the markets would understand that the fed funds rate will probably have to go up to 4% or 5% by the end of the year,” he said.

Market expectations, based on the CME’s Fed Watch tool, are that the Fed will raise its key rate to a range of 3% to 3.25% by the end of the year and that rates will reach a range from 3.5 to 3.7% by July 2023. .

Discussions on a possible Fed benchmark rate of 4% to 5% resumed this week.

Former Dallas Fed President Richard Fisher said he thinks a 5% federal funds rate “is a decent level.”

Harvard economics professor Ken Rogoff said the idea that the Fed would stop raising its benchmark rate when it hits 3% “is really unlikely.”

Deutsche Bank economists see the Fed raising interest rates to as high as 3.6% by mid-2023. Combined with the effects of its balance sheet liquidation, which have similar impacts of rate hikes, the Fed will realize more than 4 percentage points of effective tightening, the Wall Street bank estimates.

“This tightening is expected to begin to slow growth significantly in the second half of 2023 and induce a recession that will begin late next year,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank, in a note to journalists. clients.

“We will be interested in knowing how the FOMC interprets the appropriate nominal neutral rate in an environment where inflation is significantly above the Fed’s 2% target,” he added.

Some fixed income experts think the Fed’s benchmark rate could hit 6%, while other economists and strategists think the Fed won’t be able to raise rates even to 3%.

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Ellen Gaske, chief economist at PGIM Fixed Income, said she believes, subject to a lot of uncertainty, the Fed will only raise rates to 2% by the end of this year and 2 .5% in 2023.

She said companies would lose pricing power and there would be some moderation on wage gains.

These views are informed by the last round of Fed tightening, where the Fed attempted to raise rates to a “neutral” level – which it said was around 3% – but backed off. round after rates hit a range of 2.25% to 2.5% in December 2018 and financial markets swooned.

Marvin Loh, senior global macroeconomic strategist at State Street, said the Fed will stop raising rates “somewhere in the 2.25% to 2.5% range” either at the end of this year or at the start of it. next year.

“I think it’s as high as it gets,” he said.

Loh said there could be some inflation-friendly printing later this year. “I think there’s a chance that we’ve had an inflation spike and then it really becomes a matter of how quickly it comes down,” he said.

Loh said he didn’t think the economy would be able to withstand much tighter financial conditions and there was a chance core CPI would be in the 4% range by now. the end of the year.

The return on the 10-year treasury bill
TMUBMUSD10Y,
2.939%

reached 3% on Monday before stepping back.

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