Lawler: More Ruminations on the “Neutral” Rate of Interest
"the current stance of monetary policy is not meaningfully restrictive"
From CR: Housing economist Tom Lawler has written extensively on the “Neutral” rate, for example, see Update on the “Neutral” Interest Rate, Lawler: Update on the “Neutral” Rate and Lawler: Mortgage Rates Have Surged Since the Federal Reserve Cut Interest Rates Last Month.
In his testimony to Congress yesterday, Fed Chair Powell said: “This is my own view, and there are many different views on this, but it is that the neutral rate has risen meaningfully … from what was clearly very, very low before the pandemic … [as do] many of my colleagues on the FOMC"
This is important for mortgage rates, and a reason why mortgage rates are probably in a “new normal” range.
The following is from housing economist Tom Lawler: More Ruminations on the “Neutral” Rate of Interest
Let’s Be Real
When talking about the so-called “neutral” interest rate, many financial commentators, financial analysts, and even monetary policymakers talk about the nominal interest rate. However, the theoretical “neutral” interest rate is a real, or inflation-adjusted interest rate.
For example, in Fed Chairman Powell’s January 29 press conference, when asked “just how far away you think you are from neutral,” responded as follows:
“Yeah, you can't know with any precision, of course. As I like to say, that you know that, you know the neutral rate by its works. So, I think at 4.3 percent we're above pretty much everyone on the Committee's estimates of the longer-run neutral.”
An obvious problem with his comparing today’s nominal fed funds rate to FOMC participants’ estimates of the “long-run” neutral fed fund rate is that ALL participants’ long-run estimates assume that inflation and inflation expectations in the “long-run” are at two percent, which (as Chair Powell noted elsewhere) is obviously not the case today. While today’s inflation and inflation expectations aren’t clear – surveys vary, as do various measures of inflation – it would appear as if expected inflation over the next year is around 2.6%, leaving the current “real” fed funds rate at around 1.7%. While that is above most FOMC participants estimates of the long-run real neutral rate – which is appropriate since inflation is still above the 2% target – is at or very close to about 30% of FOMC participants’ long-run estimates.
Of course, comparing today’s “real” fed funds rate to FOMC participants’ expectations of the “long-run” real funds rate isn’t all that relevant, given the FOMC participants’ record on projecting that rate. In addition, the range of FOMC participants’ expectations for the long-run real fed funds rate – from a ridiculously low 0.375% to 1.75% -- is exceptionally wide.
A more interesting question to Chairman Powell might have been the following: What is the financial market’s assessment of the extent to which current monetary policy is restrictive, and more specifically why is the market’s view of the long-run “neutral” fed funds rate so much higher than that of most FOMC market participants?
What does “the market” say?
While there are no clear measures of “the market’s” expected value of the “neutral” fed funds rate, there are some ways to estimate that expectation.
In terms of nominal rates, the Federal Reserve Bank of Atlanta publishes a daily “Market Probability Tracker” based on futures and options for the Secured Overnight Financing Rate (SOFR), which tracks the fed funds rate. Here is a description from the website.
The Market Probability Tracker estimates probability distributions implied by the prices of options from the Chicago Mercantile Exchange that reference the three-month compounded average Secured Overnight Financing Rate (SOFR). SOFR, published by the Federal Reserve Bank of New York, broadly measures the cost of overnight (one-day) loans collateralized with Treasury securities in the repurchase agreement, or repo, market. Because the New York Fed's Open Market Trading Desk implements monetary policy through repo market transactions, we can use the estimated distributions to make inferences about the market's assessment of future target ranges that the Federal Open Market Committee sets.
Updates are made daily using the most recently available data, typically from the previous day. In this tracker, we show results from the four nearest-expiring quarterly contracts. To observe changes in the market's assessment, users can view and compare estimates across the prior six weeks for the market's expected three-month average SOFR path and its 25th- to 75th-percentile region; the probabilities associated with future target ranges over the quarterly intervals specified by individual contracts; and the full distribution estimated by our model.
On January 31 the “expected” 3-month SOFR for September 15, 2027 (the latest date shown) was about 4%, with the 25th and 75th percentiles ranging from around 3% to around 4 7/8%. Expectations from FOMC participants ranged from 2 3/8% to 3 7/8%, with 10 participants showing an expectation under 3%.
Part of that difference may reflect a gap between the market’s expectation for inflation and FOMC market participants’ expectations for inflation. For 2027 17 of 19 FOMC market participants’ projection for inflation was 2%, while the market’s expectation for 2027 inflation base on zero-coupon inflation swaps was about 2.5% -- suggesting a market expectation for the “real” fed funds rate near the end of 2017 of around 1.5%.
Stated another way, using this methodology the difference between the market’s expectation for the federal funds rate and the median expectation of the “appropriate” fed funds rate for the end of 2027 would be as follows:
Another way to approach this question would be to look at implied forward Treasury yields, adjusted for any term premium. Unfortunately, the term premium embedded in the Treasury yield curve is not observable. For this exercise I will use two widely followed estimates of the Treasury term premia: one from researchers at the Federal Reserve Bank of New York, and the other from researchers at the Federal Reserve Board.
The yield curves and term premia used are for 1/31/2025, and the inflation expectation is from CPI zero-coupon swaps.
As the table shows, the “gap” between the median “long-run appropriate” fed funds rate from FOMC participants and the implied market expectation of the long-run fed funds rate is about one percentage point, with about half attributable to higher market expectations for inflation and half attributable to a higher market expectation for the “neutral” real interest rate.
In sum, (1) the market’s view of the neutral fed funds rate is higher than the majority of FOMC participants; and (2) using implied market expectations the current stance of monetary policy is not meaningfully restrictive.
emphasis added
QT Not a Reversal of QE: Last Year Example
While the Federal Reserve has said it plans to continue reducing the size of its balance sheet, this so-called “quantitatively tightening” has not been a reversal of its previous quantitative easing. During the multiple quantitative easings over the past 15 years the Federal Reserve purchased sizable quantities of relatively long duration Treasuries and mortgage-backed securities, funding by creating extremely short duration bank reserves. Presumably these actions were designed in part to lower longer-term rates and long-term fixed-rate mortgages. A reversal of quantitative easing would have involved selling long-duration Treasuries and MBS, with the proceeds used to reduce the quantity of short-duration bank reserves. That, of course, has not happened. Instead the Federal Reserve has let its balance sheet shrink by not reinvesting all of the maturing (and by definition short duration) Treasuries in new Treasuries, and not reinvesting all MBS prepayments in new MBS or Treasuries.
In fact, last year the Federal Reserve added $184.8 billion of Treasury notes and bonds to its System Open Market Account (SOMA) with a weighted average maturity of 8.11 years, as well as $3.49 billion of TIPS with a weighted average maturity of 10.52 years. Included in the Fed’s Treasury purchases were $36.0 billion of 10-year Treasury notes and $21.1 billion of 30-year Treasury bonds that were issued last year. The weighted average maturity of SOMA Treasury holdings at the end of last year was 8.87 years, up from 7.86 years at the end of 2022 and massively higher than the 3.2 years in the 2004-2006 (pre-financial crisis) period.
While it is not exactly clear why the Fed has done what it’s done, one possible reason is that the Fed did not want its “quantitative tightening” to have a material upward impact on long-term rates.Or stated another way, it did not want its “QT” to make monetary policy more restrictive, or to result in a material increase in Treasury term premia.
Others have argued that the Fed did not want to sell long-term Treasuries or MBS previously purchased because the Federal Reserve would have to realize sizable market losses.
Whatever the reasons, it is absolutely obvious that the quantitative tightening over the past few years has not even remotely been a reversal of the previous quantitative easing.
NOTE: This was from housing economist Tom Lawler.