New Neutral Nirvana?

Joachim Fels, PIMCO Global Economic Advisor

Joachim Fels

Following a turbulent December characterized by volatile markets and the Fed’s fourth rate hike in 2018, which brought the upper limit of the target range for the federal funds rate to 2.5%, U.S. monetary policy looks set to enter a new phase: The Fed appears to have arrived at, or close to, the end of the rate hike cycle and the policy rate should now broadly flatline at or close to current levels in the foreseeable future.

Fed policymakers’ new buzzword is that they can be “patient” as they see how the data evolve in 2019. Fed chair Powell introduced the new language at the panel with his two predecessors on January 4; the FOMC minutes released last Wednesday then confirmed that “patient” already featured in the Committee’s discussions in December; and several other Fed speakers have emphasized the p-word over the past week. Witness how Fed vice chair Rich Clarida concluded his speech in New York on Thursday (bolding added):

“We begin the year as close to our assigned objectives as we have in a very long time. I believe patience is a virtue and is one we can today afford.”

Interestingly, the 2.5% upper limit of the fed funds target range not only equals the lower end of the range of FOMC participants’ estimates of its longer-run equilibrium level, r*. It is also smack in the middle of the estimated 2-3% range of what we at PIMCO have been calling the ‘New Neutral’ policy rate for the past five years. Most of you will recall that Rich Clarida played an important role in developing and popularizing the ‘New Neutral’ concept during his time at PIMCO. As Rich used to point out in the past, the ‘New Neutral’ is an anchor, but neither a floor nor a ceiling for actual policy rates. At this stage, however, the anchor appears to be very strong.

As I see it, both the economy and markets are signaling that the Fed has indeed arrived in the zone where policy is broadly neutral and thus neither stimulating nor hindering the economy:

  • Economic growth, which was exceptionally strong last year helped by a large fiscal stimulus, has slowed recently and is now widely expected to ease closer to its underlying trend in the course of this year.
  • The unemployment rate fell below 4% last spring and thus near a 50-year low, but has been bumping broadly sideways since then.
  • Core inflation has been running close to the 2% target over the past year. Wage growth has accelerated, but so has productivity, thus keeping unit labor costs subdued.
  • Moreover, the yield curve is now almost perfectly flat, which indicates that markets also believe the Fed has reached the neutral zone.

    Against this backdrop, and barring major shocks, there is a good chance that the Fed funds rate will float broadly sideways at or close to the current level for quite some time. Note that we think the Fed may well tighten again later this year following a pause, but this would unlikely be a precursor to another series of rate hikes.

    If the middle of our 2-3% ‘New Neutral’ range will indeed serve as a magnet for the fed funds rate in the foreseeable future, what are the implications? Today, I will speculate only briefly on a few as I plan to return to the topic in the next several weeks.

    First, if the Fed keeps rates in the neutral zone rather than pushing them into restrictive territory, the expansion has more room to run – that’s the good news. The bad news is that if rates indeed peak at current or only slightly higher levels, the Fed only has about 250 basis points to spend if and when the next recession arrives – only half of the ammunition it spent in previous downturns.

    Second, an extended flatlining of the funds rate could end the yield curve flattening trend that had been in place during much of the Fed’s tightening cycle. As the Fed is likely to continue to run down its balance sheet during the most or all of this year and fresh bond supply will be ample due to the large budget deficit, the next major move in the curve is more likely a steepening than a flattening.

    Third, the end or near-end of the hiking cycle may end or even reverse the dollar uptrend that has been in place since last spring. However, given the economic weakness and political uncertainties in Europe and China’s ongoing slowdown, it is hard to have much conviction at this stage.

    Fourth, a ‘New Neutralist’ Fed and a potential dollar-stabilization or even reversal would remove two of the three external negatives for EM assets that operated for much of last year. However, the third external negative – China’s growth slowdown – remains in place for now, which calls for continued caution on EM.

    Fifth, an end or near-end of Fed tightening will make it even more difficult for the ECB and the Bank of Japan to start exiting from negative policy rates this year as the risk of an unwelcome currency appreciation (unwelcome because inflation remains significantly below target) in response to a more hawkish stance increases. This means both central banks will have virtually no ammunition if and when the next recession hits.

    All said, enjoy the ‘New Neutral’ nirvana as long as it lasts.