Wall Street Remains On A Collision Course With The Federal Reserve's Reality

Raising Rates To The "Neutral" Rate Means The Current Rates Are NOT Neutral

One of the more arcane concepts floating around the Federal Reserve’s inflation strategy is that of the “neutral” interest rate.

In theory, the neutral interest rate is the rate at which monetary policy is neither stimulating nor restricting economic growth. As Fed Vice Chair Lael Brainard put it in a 2018 speech, it’s the level “that keeps output growing around its potential rate in an environment of full employment and stable inflation.” (The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.)

Earlier this year, the Federal Reserve estimated (guess-timated?) the "neutral rate" to be 2.25%-2.5%, according to Chicago Federal Reserve President Charles Evans.

Evans repeated comments he made on Tuesday, reiterating his stance that the Fed will likely raise its policy target range to 2.25%-2.5% by year end and then take stock of the state of the economy, but if inflation remains high would need to hike rates further.

The Federal Reserve set the Federal Funds Rate at that “neutral rate" back in July. The Fed would appear to have either overshot their “neutral rate” with rate hikes since then, or greatly misestimated the “neutral rate”.

Many Fed watchers are of the belief that as the Federal Reserve raises rates to their internal estimate of the “neutral rate”, they will slow down the pace of rate hikes.

[Sonia] Meskin of BNY Mellon Investment Management worried that there is only a small chance that the economy could achieve a successful “soft landing” — a term used by economists to denote an economic slowdown that avoids tipping into recession. 

“The closer they (Fed) get to their own estimated neutral rates, the more they try to calibrate subsequent increases to assess the impact of each increase as we move into a restricted territory,” Meskin said via phone. The neutral rate is the level at which the fed-funds rate neither boosts nor slows economic activity.

However, this leads directly into a problem for both the Fed and for Wall Street—and quite possibly for Main Street as well.

If the goal for the Federal Reserve is to keep interest rates at or near the “neutral rate”, and that “neutral rate” is higher than the 3.75%-4% set last Wednesday’s FOMC meeting, then the Fed has been holding interest rates below the neutral rates—i.e., interest rates were presumably boosting economic activity.

It means interest rates were below the neutral rate in the first half of this year, during which the economy contracted 2.6%.

Just Don't Call It A Recession

If the Fed has been in effect “boosting” the economy all this time by holding interest rates low, then raising rates back to neutral removes that boost. If the “boosted” economy contracted 2.6%, by how much will the “non-boosted” economy contract?

If, on the other hand, the Fed is intentionally pushing rates past the neutral rate, as Jay Powell suggested they would do in his Jackson Hole speech¹, by how much will the deliberately decelerated economy contract?

We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. At our most recent meeting in July, the FOMC raised the target range for the federal funds rate to 2.25 to 2.5 percent, which is in the Summary of Economic Projection's (SEP) range of estimates of where the federal funds rate is projected to settle in the longer run. In current circumstances, with inflation running far above 2 percent and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.

In either situation, the economy contracts, and by more than 2.6%.

Wall Street’s persistent belief is still that the Fed will not author a recession.

“The Fed would have liked to see a greater impact from the tightening through Q3 this year on the financial conditions and on the real economy, but I don’t think they’re seeing quite enough of an impact,” said Sonia Meskin, head of U.S. macro at BNY Mellon Investment Management. “But they also don’t want to inadvertently kill the economy…which is why I think they’re slowing the pace.”

Yet the mere contemplation of a neutral rate of interest shows this belief to be wholly delusional. Not only will the Fed author a recession—and a deep one—but the Fed cannot help but author a recession with its current rate hikes. Either the economy will contract without non-neutral interest rates boosting it, or the economy will contract because of non-neutral interest rates slowing it down. There is no third option available.

The Federal Reserve will author a recession. It will probably be a long and deep recession. Yet Wall Street persists in keeping its head stuck in the sand and denying the evidence in front of us all.

That denial will end the way all such denials end—by Wall Street getting gobsmacked by reality. And the gobsmack is coming.

1. Powell, J. H. Speech by Chair Powell on Monetary Policy and Price Stability. 26 Aug. 2022, https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm.