There is some speculation that the Fed may begin to raise its estimate of the long-run neutral rate, currently 2.5%, entirely because the real rate estimate of 0.5% is judged to have been too low. Henceforth I will refer to the real rate as r*, conventionally.
The idea that r* has risen makes sense to me. The steep surge of the federal debt in recent years should have raised equilibrium rates by more than private sector trends would tend to have reduced it, particularly as those private sector trends may be getting less potent. And that has been a mostly benign development because it reduces the risk of liquidity trap and may help resolve a problem related to incomplete markets. It is plausible that the Fed begins to recognize that rise today.
However, there are a couple practical matters here that are worth reiterating. First, estimates of the real rate play virtually no role in the Fed real-time implementation of monetary policy, which is the only kind there is. One of several reasons for this is that there is a lot of slippage between the r vs r* gap and the state of financial conditions, which we all agree is the Fed’s immediate target, with the funds rate being just the primary instrument. We can see evidence of the broad acceptance of this simple point in one of the arguments for a higher estimate of r* making the rounds. It runs that the Fed might take up its estimate of r* because financial conditions are relatively easy. So, true. Now apply Occam, allow r* to cancel out of the arithmetic, and recognize that the Fed watches financial conditions. How they are best measured is controversial, but they are what the Fed monitors. To be sure, the Fed does not monitor a fixed level of financial conditions. The target there is a function of cyclical economic conditions. And this further undermines the idea that the Fed targets an r vs r* gap, because that would be unhelpful even if the gap were a proxy of financial conditions, which it is not.
Estimates of r* are much more relevant when thinking about the fair-value of long-duration fixed income securities. Every bond market participant has an estimate in her head of the level of r*, even if unwittingly. But it does not follow from this that the Fed’s estimate is driving things. Again, I can refer to an argument making the rounds. That story there runs that one reason the Fed needs to raise r* is that forward prices imply that r* must have risen. So true! But it recognizes explicitly that the market leads here. I concede that a “confirmation” from the Fed might have some minor and transitory effect, but the Fed’s estimate is very obviously not the main driver here.
Somewhat related to my first caution, let’s see if Jay Powell continues to characterize financial conditions as tight. If he does, then he is implicitly saying that I am wrong and that they watch just the funds rate. In my view, that is a serious misstatement of what they clearly believe. But taken in isolation, it would be a dovish comment. And for the very immediate future it would be particularly dovish, because the nonsense of it actually makes it a stronger signal. It would have to be a stand-in for some other concern. On the other hand, it would not be a new comment, as Powell has been on about this for a while. And of course, other comments will matter as well.
The funds rate is the main instrument, but below is an estimate of the immediate target
Data are to the close yesterday.
