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Are Interest Rates at Neutral? Markets Certainly Hope So

WASHINGTON, DC - JULY 27: U.S. Federal Reserve Board Chairman Jerome Powell speaks during a news conference following a meeting of the Federal Open Market Committee (FOMC) at the headquarters of the Federal Reserve, July 27, 2022 in Washington, DC. Powell announced that the Federal Reserve is raising interest rates by three-quarters of a percentage point. (Photo by Drew Angerer/Getty Images)
WASHINGTON, DC - JULY 27: U.S. Federal Reserve Board Chairman Jerome Powell speaks during a news conference following a meeting of the Federal Open Market Committee (FOMC) at the headquarters of the Federal Reserve, July 27, 2022 in Washington, DC. Powell announced that the Federal Reserve is raising interest rates by three-quarters of a percentage point. (Photo by Drew Angerer/Getty Images) (Photographer: Drew Angerer/Getty Images North America)
Comment

One of Federal Reserve Chair Jerome Powell’s unscripted remarks at his press conference on Wednesday — that interest rates have reached a “neutral level” after the just-announced 75-basis-point interest-rate increase — is sure to prompt much discussion among economists in the weeks and months ahead. Judging from how markets reacted the minute he made this remark, it is clear what conclusions the vast majority of investors want these economists to reach.

Neutral is shorthand for the crucially important notion that the level of interest rates is consistent with monetary policy being neither contractionary nor expansionary. When combined with the Fed’s dual mandate, it signals a monetary policy that is close to being set to deliver maximum employment and price stability.

In today’s world, this is translated by markets into the view that the Fed now believes that it has already done the bulk of what is needed to tighten monetary policy to deal with what Powell himself described as inflation that remains “much too high” and is inflicting “considerable hardship” on Americans.

Given this interpretation, it should come as no surprise that, immediately after Powell uttered the word “neutral,” stocks, bonds and the dollar all moved significantly and exactly as textbooks would suggest: Stocks surged, with the main indexes ending the session 1.4% to 4.1% higher; bond yields fell, with the two-year Treasury dipping below 3% and the curve inversion for the two-year and 10-year Treasuries moderating to 20 basis points; and the dollar weakened, with the DXY index falling to 106.4.

Each of these moves serves to ease financial conditions. No wonder markets set aside other unscripted remarks by Powell that are hard to immediately reconcile with his assertion that rates are at neutral. This included the likelihood of a higher natural rate of unemployment; the considerable amount of economic uncertainty; the need for the Fed to go “meeting by meeting” on its policy decisions; and the difficulty of providing clear forward policy guidance.

Count me among those hoping that Powell is entirely correct that rates are already at neutral. This would improve the chances of the Fed being able to soft-land the economy, thereby reducing inflation with limited damage to livelihoods and without triggering unsettling financial instability.

I have no precise estimate for neutral for the very reasons that Powell mentioned regarding the unusually high level of uncertainty and the changing structural parameters of the economy. As to the general neighborhood for that level, I have a hunch, but am far from certain, that we are still below it.

I hope I am wrong. If not, this will sadly end up amplifying my often-repeated concerns about the collateral damage to the economy and livelihoods, especially those of the more vulnerable segments of society, of a Fed that took way too long to understand and to respond properly to inflation.

More From Other Writers at Bloomberg Opinion:

• Why the Federal Reserve Should Keep an Open Mind: Editorial

• Do You Think Fed Hasn’t Done Enough? Think Again: Nir Kaissar

• Inflation Beast Won’t Lie Quietly Again: Allison Schrager

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”

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