Macroscope: Neutral matters
For something that cannot be directly observed, and changes through time, the neutral level of interest rates generates an awful lot of debate, says Ninety One Investment Strategist Russell Silberston
The Federal Reserve Board of Dallas defines US neutral rates as the ‘theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.’ To convert this unobservable real interest rate into a nominal neutral, policy makers simply add their inflation target.
Therefore, even though nobody really knows where neutral is, it is an important lodestar for both policymakers and market participants, as it indicates whether the monetary policy goal is to stimulate or restrain an economy. Additionally, with monetary policy being rapidly tightened in most Western economies, it takes on added importance as a compass point for those setting interest rates.
At their July Governing Council meeting when official interest rates were increased by a larger than expected 50 basis points, European Central Bank President, Christine Lagarde declared that ‘the ultimate destination of our policy path remains the same, which is to progressively raise interest rates to a broadly neutral setting.’ This is remarkably similar to communication from the Federal Reserve back in March, when Chair Powell, following their first increase, stated ‘frankly, the need is one of…getting rates back up to more neutral levels as quickly as we practicably can and then moving beyond that, if that turns out to be appropriate.’
However, despite the similarities between the communication, the European Central Bank steadfastly refuses to discuss where neutral interest rates are. In fact, President Lagarde went further, stating at the post-hike press conference ‘What is the neutral setting? At this point in time I don’t know…So we will cross that bridge when we cross that bridge.’ The Federal Reserve, in contrast, publishes its own assessment of neutral once per quarter as part of their Summary of Economic Projections. In June, this was deemed to be 2.5%, which would comprise their 2% inflation and an estimated 0.5% real rate.
Why does this matter? After all, neutral rates are ‘theoretical.’ Quite simply, if one knows the destination and route for monetary policy, it helps anchor financial markets and so lowers volatility. This year has seen an aggressive sell off in global bond markets as expectations have re-priced. However, US medium term interest rates, as proxied by 5 year forward swap rates, have hovered at 2.5% – the Fed’s assessment of neutral – since the end of Q1 22, despite official interest rates rising 1.75% with another 1.00% priced.
In the Eurozone, over the same period, the equivalent forward interest rate has risen from 1.5% to 2.9% and back to 2% as the market tries to understand where eurozone monetary policy is headed. Policy making in the Eurozone is further complicated by an incomplete Monetary Union and, for a highly indebted economy such as Italy, interest rate volatility is especially unwelcome as the relationship between debt and solvency are not linear.
Simply saying we don’t know where neutral rates are, and we’ll worry about them later is bordering on irresponsible. It will increase volatility, undermine those eurozone economies that continue to struggle under the burden of their government debt, and may force the ECB to over-tighten, all of which risks weakening the euro further. As such, this is counterproductive to the ECB’s inflation busting strategy.
The European Central Bank needs to overcome its dislike of neutral and start thinking about discussing a plausible range of possibilities if it wishes to minimise the risks inherent in a monetary policy tightening cycle. It might be theoretical, but neutral rates matter in practice.