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Fed lowers long-run US rate outlook as growth prospects dim

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Chairman Jerome Powell and colleagues last week estimated that the so-called neutral interest rate - the level which neither stimulates nor restricts growth - now sits around 2.5 per cent, down from 2.75 per cent in March and as high as 4 per cent in 2014.

Atlanta

FEDERAL Reserve policy makers are discovering they likely need to shift into an even lower gear than in recent history if they are to speed up the US economy.

Chairman Jerome Powell and colleagues last week estimated that the so-called neutral interest rate - the level which neither stimulates nor restricts growth - now sits around 2.5 per cent, down from 2.75 per cent in March and as high as 4 per cent in 2014. That means the Fed's current benchmark of 2.25-2.5 per cent is unlikely to provide the power policy makers once assumed it would, leaving eight of them anticipating they will have to reduce rates this year amid growing risks to the economic outlook.

"This is really important," said Torsten Slok, chief economist at Deutsche Bank Securities, who expects a rate cut in July. "For many years, the Fed has been arguing that monetary policy was easy and accommodative and supporting growth and inflation. After a decade of easy monetary policy, the Fed has decided that policy is no longer stimulative."

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Reasons listed for the lower neutral rate include ongoing fallout from the financial crisis, weaker productivity, continued slackness in the labour market and an ageing population, which when combined leave the economy structurally weaker and so more vulnerable to rate hikes.

The upshot is the Fed may have to lower rates if it wants to boost expansion to offset global headwinds, including slow global growth and trade disruptions from President Donald Trump's tariff battles.

Fed funds futures contracts are pricing in at least a 25-basis-point cut in July, with roughly 44 per cent chance of a 50 basis-point cut.

Those expectations for a steeper drop in the policy rate have grown in the days since Mr Powell signalled a willingness to act swiftly "as needed" to protect the economy.

"They have come to the conclusion that growth is slowed by productivity and demographic factors that predate the Great Recession and that are not reversing soon," said Jonathan Wright, a Johns Hopkins University economics professor and a former Fed researcher.

Mr Trump has targeted US growth of 3 per cent or more, a goal met last year because of fiscal stimulus including a US$1.5 trillion tax overhaul. Kevin Hassett, outgoing chairman of Trump's council of economic advisers, reiterated earlier this month he still expects 3 per cent growth this year. "I'm not trimming it back," he said on June 3.

Fed officials didn't explain their reasoning in changing the forecasts in the Summary of Economic Projections. While some including Mr Powell have said they hope tax and fiscal policies will boost productivity, their lowering of the neutral rate is a concession they are not expecting that to be sustained. They estimate long-term growth at 1.8 per cent to 2 per cent.

"There was never going to be a big pick-up in growth," said Brad DeLong, an economist at University of California at Berkeley, who worked in the Treasury Department in the 1990s with Lawrence Summers, and like Mr Summers has cautioned growth is in a period of "secular stagnation".

Mr DeLong cites low inflation, high savings and risk aversion by borrowers. "It is not a surprise."

Estimates of neutral - sometimes called R-star - have helped to guide Fed policy for years as a loose benchmark that didn't get too much attention.

Mr Powell raised interest in the theoretical rate last October when he allowed that rates were "a long way from neutral", implying many hikes to get there. He backtracked a month later by saying rates were just below a range of estimates of neutral.

The Fed's target rate has never peaked at such a low level, rising to more than 5 per cent before the last two recessions. Rates averaged 4.8 per cent in the 20 years ended in 2007.

"Low neutral interest rates are very real, and they're here to stay," New York Fed president John Williams, a leading researcher of the neutral rate, said in a speech in June.

He cited low productivity, slower population growth and a decline in demand for savings.

Mr Williams and two Fed colleagues, Kathryn Holston and Thomas Laubach, have used economic data in a model estimating neutral, at 0.42 per cent as of the first quarter, implying a rate of about 2 per cent or so, when inflation is included.

That compares to rates of more than 5 per cent in in the 1960s and 3.5 per cent as recently as the late 1990s. BLOOMBERG