MACRO AND MARKET PERSPECTIVES

Navigating interest rates by the North Star

Nov 19, 2018
By BlackRock Investment Institute

We believe the neutral interest rate can help guide the overall direction of monetary policy. It therefore also impacts asset valuations. Yet traditional models only focus on the long-term neutral rate, which can be buffeted by short-term financial forces. We add the impact of financial cycles when estimating neutral rates and find that the Federal Reserve has reason to keep tightening policy in line with its own rate projections – above market expectations – to get to a neutral policy stance by the end of 2019.

Highlights

  • We arrive at a new estimate for neutral rates – also known as r-star (r*) – and introduce a new short-term neutral rate that incorporates financial cycle booms and busts. When the financial cycle is heating up through robust credit growth, the neutral rate that stabilises the economy may be higher than traditional, long-term estimates.
  • The current US financial cycle argues for the Fed to lift rates higher than market expectations to prevent the economy overheating – especially with the economy at full capacity and inflation near the 2% target. It is different in the eurozone. A subdued financial cycle keeps our short-term estimate of neutral below its long-term trend. That suggests the European Central Bank should keep monetary policy looser than the long-term trend to boost risk appetite.
  • The neutral rate is useful when gauging the risk of a big correction in financial markets. Equity markets are historically more volatile when rates approach neutral. Volatility aside, our estimates of the neutral rate suggest that from a macro viewpoint US equity market valuations may not be as stretched as commonly thought.
  • R-star for central bankers is like the North Star for sailors – a crucial guide. Fed Chair Jerome Powell said “navigating by the stars” is tough because the stars keep moving. But central banks cannot ignore the debate, in our view: Neutral rates have become a key part of communication and forward guidance. Based on our short-term neutral rate, the Fed pushing rates up to its median projection would not represent a significant overshoot and would only just nudge policy towards the tight side.

Snapshot

The actual Fed policy rate remains some way below our estimate of the level of the neutral rate. This signals that U.S. monetary policy should still be providing some stimulus to the economy although to a smaller extent than several years ago when the gap with neutral was larger. This suggests that the Fed can hike rates further before it reaches a neutral stance. Indeed, the most recent median forecast of Fed policymakers (represented by the orange dots in the chart) project that interest rates will just reach where we estimate the level of neutral to be. While we see room for rates to rise, they will likely remain at historically low levels.

Chart: Defence of the dost
Jean Boivin
Global Head of Research, BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is Global Head of Research for the Blackrock Investment Institute and is a member of the EMEA Executive Committee.
Head of Economic and Markets Research, BlackRock Investment Institute
Deputy Head of Economic and Markets Research, BlackRock Investment Institute