An interest rate rise would take the froth out of the US economy

The Fed should act to prevent the build up of imbalances within the financial sector

Elga Bartsch

The Federal Reserve in Washington DC where central bankers are cautious about publicly stating what interest rate would allow GDP to expand at its long-term trend rate © Reuters

US interest rates are climbing towards a level that many market participants deem neutral for growth and inflation. But US central bank officials, notably Federal Reserve chairman Jay Powell, seem to be less enthusiastic about publicly stating what interest rate would allow gross domestic product to expand at its long-term trend rate.

Part of their criticism is understandable; there is much uncertainty surrounding the estimates of the neutral interest rate level. But whether central bankers like it or not, the concept of a neutral interest rate provides a centre of gravity for investors’ expectations for long-term interest rates. That means neutral rates must inevitably be part of the forward guidance that a central bank provides on its future policy rates.

Most estimates of the neutral interest rate level ignore a key feature of the long-term equilibrium that central banks are aiming to achieve. While their main goal is to keep the economy on an even keel long term, central banks also try to steer the financial cycle towards a steady state, avoiding credit booms and busts. This second goal has increased in importance in recent decades as financial cycles have become longer and more extreme.

BlackRock estimates that, if the bank took into account the financial cycle as well as the economic one, the neutral interest rate level in the US would be about 3.5 per cent. That is considerably higher than the Fed funds rate of 2.25 per cent. We also believe the current neutral rate is probably higher than its long-term trend rate of about 3 per cent. The difference is due to the extended period of strong credit growth in the US since the 2008 crisis.

This deviation has key implications for monetary policy. During the financial crisis, falling confidence and declining debt pushed the neutral rate below its long-term trend. That meant that the Fed had to cut policy rates further to stabilise the economy. Over time, the scars have healed, and we have seen a period of sustained increase in borrowing, especially by the corporate sector. This has pushed the neutral rate back above its long-term level.

Hence,I believe the Fed should do what is known as “leaning against the wind”: raise rates to contain overheating in the economy and prevent the building up of imbalances within the financial sector.

The actual Fed funds rate, which measures the cost of borrowing “excess” the Fed reserves overnight without collateral, remains more than 100 basis points below our estimate of the neutral level. So US monetary policy should still be very supportive of economic growth and encourage investors to favour riskier assets.

That said, the Fed is raising interest rates and shrinking its balance sheet. It is therefore providing less economic stimulus than right after the crisis. That means it could lift rates further before monetary policy would start to weigh on economic and credit dynamics in a meaningful way. The median forecast of the members of the Federal Open Market Committee, which sets the rate, is only inching towards the neutral level of US interest rates, BlackRock estimates.

The outlook for economic growth in the US therefore is still good. But the support provided by monetary policy and last year’s tax cuts will gradually diminish next year. Our estimate of the neutral rate of interest suggests that 10-year US Treasury yields are relatively close to their equilibrium level.

The current Fed tightening cycle will probably peak at a much lower level than previous ones. As a result, investors are likely to be willing to accept higher equity prices for the same predicted earnings in the long run. That means the US equity market does not look materially overvalued. In fact, solid corporate earnings and strong economic growth would underpin a positive view on equities.

The writer is head of economic and markets research at BlackRock

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