BLACKROCK INVESTMENT INSTITUTE

Our take on the "neutral" rate

19-Nov-2018
By Richard Turnill

Key points

  1. The Federal Reserve’s policy rate is closing in on the “neutral” level. This could raise uncertainty around the Fed’s future rate path, we believe.
  2. Oil prices tumbled amid concern about demand weakness. Chinese equities outperformed developed markets as trade worries eased.
  3. Markets are looking for signs of a rebound in the manufacturing data from key economies after October signalled a disappointing start to the quarter.

Our take on the “neutral” rate

A key input into the Fed’s policy decision-making is its assessment of the “neutral” rate of interest – the rate at which monetary policy neither stimulates nor restricts growth. Our estimates show the Fed’s policy rate is still below neutral – or slightly stimulative. Yet as neutral nears, new uncertainties on the Fed’s rate outlook emerge.

Chart of the week

Fed policy rate and estimates of "neutral" rates, 1990-2018.

Chart of the week

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index.
Sources: BlackRock Investment Institute, with date from the Federal Reserve, NBER and Thomson Reuters, November 2018. Notes: The Fed policy rate refers to the federal funds rate, the central bank's short-term interest rate target. The estimates for the current and long-term neutral rates are calculated using an econometric model following a July 2018 ECB working paper The natural rate of interest and the financial cycle.

The federal funds rate sits below our estimate of the neutral level, but is closing in, according to analysis by our Economic & Market Research Team. The below-neutral policy rate suggests US monetary policy should still be providing some stimulus to the economy, though this boost is much smaller than several years ago when the gap to neutral was much wider. We present two estimates of the neutral rate: long-term and current. The long-term neutral rate is considered the equilibrium level that would prevail if financial leverage followed its long-run trend. It is guided by factors including the trend pace of economic growth and long-term demand for savings. The current neutral level factors in the additional impact of the financial cycle. A sustained period of credit growth serves to push the current level of neutral up because higher interest rates are needed to stabilise the economy. Conversely, the current neutral rate falls in a period of persistent deleveraging.

Neutral and the financial cycle

The extent to which the current neutral rate deviates from its long-term equilibrium level over a financial cycle has important implications for monetary policy. In the depths of the financial crisis, depressed animal spirits and rapid private sector deleveraging pushed the current neutral rate below its long-term equilibrium level. In such an environment, the Fed had to cut its policy rate even further below the long-term neutral level. Over time, the wounds of the crisis have healed and the situation has reversed. The current period of sustained re-levering has pushed the neutral rate back up above its long-term level. This implies the Fed would have to “lean against the wind” and push rates higher in order to prevent overheating pressures from building up.

The closer the Fed gets to neutral, a milestone it has been pursuing gradually for nearly three years, the greater the uncertainty over the interest rate outlook. For one, there is inherent uncertainty around the Fed’s assessment of “neutral” given that it is an unobservable metric that can only be estimated statistically. Fed Chairman Jerome Powell has signalled he prefers to place less emphasis on the neutral rate in Fed communication given the difficulty in pinning it down. The Federal Open Market Committee, the central bank’s policy-setting group, may become increasingly cautious as it “feels” its way toward neutral.

The narrowing gap between the Fed policy rate and the neutral level, and the rising uncertainty likely to accompany it, has implications for financial markets. The policy rate is ultimately likely to settle at levels far below pre-crisis averages. Yet for the first time in a decade, markets would no longer be under the auspices of stimulative monetary policies. This shift toward tightening financial conditions presents a hurdle for risk assets, underscoring our call for building greater resilience into investment portfolios. This implies a focus on quality and liquidity. We favour stocks of companies with strong balance sheets, ample cash flow and a healthy earnings outlook, and we find these companies predominantly in the US In fixed income, we prefer an up-in-quality bent in credit.

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  • Oil prices plunged on demand weakness concerns and technical selling. Brent crude hit eight-month lows and WTI fell to the lowest in over a year. The International Energy Agency (IEA) and the Organization of the Petroleum Exporting Countries (OPEC) both warned of a surplus in the first half of 2019. OPEC and its partners are likely to deliver another round of output cuts.
  • Tech and energy stocks led global equities down. Chinese equities bucked the trend, supported by easing trade worries on news the US has put the next round of tariffs on hold. Record-smashing retail sales on China’s “Singles Day” also lent some support.
  • European Union and UK negotiators agreed on a draft Brexit deal. It is likely to be endorsed by EU leaders on Sunday, but passage by the UK parliament – and the survival of Theresa May’s government – are in doubt. The German economy contracted in the third quarter for the first time since 2015, though a rebound is expected. Italy declined to modify its 2019 budget to meet EU rules.

 


 

  Date: Event
Nov 20 US housing starts
Nov 21 US durable goods, existing home sales; European Commission publishes opinion on Italy’s revised budget
Nov 23 Eurozone, Germany and US Purchasing Managers’ Index (PMI) reports
Nov 25 European Union and the UK hold Brexit summit

Several major economies will release their PMI figures for November. Markets are looking for a clearer sign of economic growth in the fourth quarter after October data showed slower manufacturing activity in key regions such as China and the eurozone. A rebound is expected in the eurozone data as one-off factors, such as the third-quarter disruption in auto industry production, fade.

Global Chief Investment Strategist, BlackRock Investment Institute
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active Equit

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Sources: Bloomberg unless otherwise specified.

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