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Stocks have surged because the election, while bonds are caught in a tug-of-war between bulls and bears, with participants in each markets attempting to divine the trail of the US economy under the incoming Trump administration.
At the guts of the matter lies a hotly debated topic that grips Fed economists and Wall Street alike. Something that, just like the mythical yeti, nobody has ever seen but everyone agrees exists: the neutral rate.
Kathy Jones, chief fixed income strategist at Schwab, recently joined Yahoo Finance’s Stocks in Translation podcast and described the neutral rate as “the Sasquatch of the financial world.”
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The neutral rate is easy enough to define. It is the rate of interest that neither stimulates nor slows the economy. It is the sweet spot where growth and inflation sit in balance. Too low, and the economy might overheat; too high, and growth stalls.
The issue isn’t any one really knows precisely what level of rates of interest meets this high standard.
“You model its inputs by the past,” said Jones. “Things like productivity might go into it.” She noted that if staff can boost their productivity and increase their output, the economy can grow — critically, without inflation.
Minneapolis Fed president Neel Kashkari echoed this recently on the Yahoo Finance Invest 2024 event, explaining, “In the next productivity environment, the neutral rate must be higher.” He said that if productivity is structurally higher, the Fed has less room to chop until the economy gets back to neutral.
Nevertheless, this nebulous rate is critical in shaping Federal Reserve policy.
At Invest, Kashkari echoed Fed Chair Jerome Powell’s words on the September FOMC presser, saying, “The neutral rate is just not directly observable. We understand it by its effect on the economy.”
With the Fed currently within the strategy of lowering rates, the next neutral rate implies the Fed doesn’t must cut rates as much to support the economy. Alternatively, a lower neutral rate would argue for more aggressive cuts.
Recently, investors have been coming around to the thought of the next neutral rate.
When the Fed began its rate-cutting cycle in September, investors expected the Fed to chop short-term rates to 2.8% — or a spread of two.75% to three% — by the tip of 2025. Six weeks later, the bond market is now pricing in 4 fewer rate cuts — bringing the projected rate next yr to a spread of three.75%-4%.
