Financial markets have capitulated in their expectations of US interest rate cuts this year. At the start of January, they expected at least six quarter-point cuts by the end of 2024. Now they are only sure about one. Traders are even building up bets that the next move might be up.
Borrowing costs at the end of 2024 are therefore highly uncertain. Do we know anything more about where interest rates in the US and elsewhere are ultimately heading?
Economists define this destination as R-star or the neutral rate of interest. This is the rate that balances desired savings and investment and would apply when output is at an economy’s potential and inflation was at target. It cannot be seen but can be estimated.
We know R-star occupies the Fed because chair Jay Powell said last year he was “navigating by the stars under cloudy skies”. The neutral rate was unknown, he said, but the Fed policy rate then (and now) of between 5.25 per cent and 5.5 per cent was restrictive and “well above mainstream estimates of the neutral policy rate”.
Even though the median Fed official estimates R-star to be 2.6 per cent, the important question with a resilient US economy and higher than expected inflation is whether the committee can know this. The dilemma also applies to all other central bankers.
The easy days
There was a time when all estimates of the neutral rate, whether they were based on market prices, structural models or something in between, gave similar answers. R-star had been high and declined until the pandemic.
The following well-known chart shows market rates for 10-year government bonds in the US, eurozone, Japan and UK between 1980 and the pandemic in 2019. This can be seen as a very rough proxy for R-star and other economic estimates gave similar results.
Economists and policymakers told many stories explaining the decline in nominal and real interest rates including the control of inflation, secular stagnation, a savings glut from Asian economies, rising inequality increasing savings and lower productivity and growth rates reducing the desire for investment.
Borrowing costs have risen since the pandemic, complicating this story and raising the question to what degree has R-star risen too? Do these stories still make sense or have we moved into a persistently higher interest rate world?
A world of disagreement
I am going to simplify here, but we have a big divergence. Market data, as above, suggests neutral interest rates have risen sharply. These are replicated in some much more sophisticated estimates of R-star. The alternative view, generated by more structural modelling, such as the IMF’s estimates or those from the New York Fed, say that nothing has changed. Soumaya Keynes wrote a fabulous piece about the differences in modelling last year.
The broad reasoning behind the difference of view is that methods of estimating R-star which show little change amplify the importance of long run slow-moving concepts such as the potential growth rate or demographics, while those showing the world has changed put more weight on financial market prices.
This would be difficult enough if it was not for horrible estimation problems and fundamental uncertainties over the economic meaning and drivers behind R-star.
Nightmares for economic researchers
Estimating things using econometrics is difficult. There are always data problems. These are extreme when it comes to R-star.
In March, for example, the Bank for International Settlements noted that the one standard deviation interval (in which the true value will sit only 68 per cent of the time)…
This article was originally published by a www.ft.com . Read the Original article here. .