Despite nominal interest rates at zero for years, the 2010s economy saw stubbornly high unemployment and below-target inflation. This suggests monetary policy was restrictive relative to the era's very low "neutral rate" (R-star). The low R-star meant even zero percent rates were not stimulative enough, challenging the narrative of an "easy money" decade.
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The Fed's latest projections are seemingly contradictory: they cut rates due to labor market risk, yet forecast higher growth and inflation. This reveals a policy shift where they accept future inflation as a necessary byproduct of easing policy now to prevent a worse employment outcome.
After a decade of zero rates and QE post-2008, the financial system can no longer function without continuous stimulus. Attempts to tighten policy, as seen with the 2018 repo crisis, immediately cause breakdowns, forcing central banks to reverse course and indicating a permanent state of intervention.
Fed Governor Stephen Myron argues Trump's policies will lower the neutral rate, necessitating aggressive rate cuts. Conversely, Bloomberg Economics’ model suggests these same policies—like massive government borrowing and fracturing trade alliances that reduce foreign capital inflows—will significantly increase the neutral rate, highlighting the concept's deep ambiguity in practice.
The common narrative of the Federal Reserve implementing Quantitative Tightening (QT) is misleading. The US has actually been injecting liquidity through less obvious channels. The real tightening may only be starting now as these methods are exhausted, signaling a significant, under-the-radar policy shift.
Citing Sidney Homer's "A History of Interest Rates," the speaker notes that the recent period of zero interest rates is unique across 4,000 years of financial history. This anomaly is forcing governments into debt monetization, as traditional tools are exhausted, creating a situation unlike any seen before.
Because the neutral rate of interest (R-star) is a theoretical, unobservable concept, policymakers can manipulate its estimated value to justify their desired interest rate policies. This allows them to argue for rate cuts or hikes based on a non-falsifiable premise, making it a convenient political tool rather than a purely objective economic guide.
Since 2014-2015, the Federal Reserve's actions have not materially impacted the economy's flow of funds. The intense market focus on Fed announcements is a distraction from the true economic driver: fiscal policy. Analysis should sideline the Fed to gain a clearer picture of the economy.
Robert Kaplan argues that with inflation at 2.75-3%, the neutral Fed funds rate is ~3.5-3.75%. Since the current rate is 3.75-4%, another cut would place policy at neutral, not accommodative. This is a risky position when inflation remains well above the 2% target, leaving no room for error.
The Federal Reserve’s recent policy shift is not a full-blown move to an expansionary stance. It's a 'recalibration' away from a restrictive policy focused solely on inflation toward a more neutral one that equally weighs the risks to both inflation and the labor market.
A single neutral interest rate may not exist. There could be one R-star for the investment-heavy AI sector and another for housing. A separate R-star might even be needed for financial stability. This divergence means the Fed faces a policy trade-off where a rate that balances one part of the economy could destabilize another.