Higher for longer interest rates and potentially a new neutral rate

Unemployment claims came out lower than expected this week, and as we mentioned in previous letters, the employment market still seems tight at a headline level. Additionally most recent US GDP projections have been revised upward and retail sales data out this week shows that US consumers are still spending. Where the spending is coming from, as we’ve mentioned recently, is suspect, but spending is happening nonetheless.

In an ideal world if we rewind to 12-18 months ago, the Fed would have liked to have seen the following play out:

·         Rates go up, prices go down

·         Productivity and employment go down, rates go down again

·         Lower rates make productivity and employment go back up, with new normalization of prices

This is the oversimplified model of how the Fed expects (hopes?) the economy would work, and this was basically the running assumption of how the Fed should be managing the economy for the last few decades.

The current environment is not playing out in this simplistic way – practical economics is never, ever as clean as theoretical economics. Prices have been going down, but then they kind of stopped going down and briefly bumped up as we saw recently. Additionally, productivity and employment are not reacting whatsoever to hire prices, contrary to all prior expectations. As we’ve mentioned, our view is that the spending is creating unhealthy consumer conditions that will show up elsewhere, but for now that remains a theory. The facts are thus: rates are high, prices have stopped the expected downward trajectory, yet employment is still very tight and productivity and spending are still very high.

This week, in response to the curious situation we are in, Fed President Raphael Bostic reinforced that high rates will be here for longer than expected – that much we all knew already – but he also said something very interesting and encouraging, that the “neutral rate” may be increasing. This would be a welcomed shift for anyone with the view that a decade-plus of ultra low interest rates since 2008 produced unhealthy and unstabilizing economic effects. This reinforces recent comments made by Jerome Powell at the September FOMC meeting suggesting the same thing.

The neutral rate is, per Brookings, the “interest rate that would prevail when the economy is at full employment and stable inflation”. In other words, the rate at which the economy is neither contracting nor expanding.

Here is an estimation of the real neutral interest rate over time, from the Fed.

So, rates from 2008 onward look unusually low from this timeframe. And to show that this timeframe is not a distortion of reality, check out this awesome chart from a Bank of America research report, which used data compiled by an economist from the Bank of England. This one was as of 2015, so at the time, they had no insight into the upcoming inflationary period we’re in now:

If you’re wondering what the massive spike is around the 1970’s, most of you probably correctly guessed that it’s the conversion of the economy to a full fiat society. So, based on this information alone, it’s probably safe to assume that 2008-2021 was a historically anomalous time as far as the cost of capital goes, and we’re in the process of trying to find the long-term equilibrium again.

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