In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain why the neutral rate of interest is an important metric in Federal Reserve’s fight against inflation and what it means for the housing market.

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Listen to the REconomy Podcast™ Episode 38:

“If inflation remains higher, than the neutral rate will also need to be higher. Pinning down that neutral rate of interest is really difficult in a normal year, but it's even more of a moving target in such an uncertain year. And Powell has been clear, he remains data-dependent and will raise the federal funds rate as far as it needs to go to get us to stable inflation.”
– Odeta Kushi, deputy chief economist at First American

Transcript:

Odeta Kushi - Hello, and welcome to episode 38 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American. Hey Mark, I think for today's episode, we should really reach for the stars. Well, one star in particular. Can you guess?

Mark Fleming - Hi, Odeta. Stars? There are so many kinds of stars, you're gonna have to give me a little bit more information than that.

Odeta Kushi - Sure thing. What's a pirate's favorite letter?

Mark Fleming - Okay, oh, I get it. Reach for the stars, a pirate's favorite letter, we must be talking about the elusive 'r-star.'

Odeta Kushi - Right. And if you're a little confused listener, r-star refers to the natural or neutral rate of interest. It's been getting a little bit more attention these days, because Federal Reserve Chairman Jerome Powell recently brought it up at a press conference after the Fed announced a 50-basis point hike in the federal funds rate. But, before we get into what he said, and what implications that has, what the heck is it?

Mark Fleming - Great question, Odeta. Okay, I'll try this without too much economic jargon, which is going to be difficult on this one. Yes. It's the short-term interest rate level when the economy is both at full employment and inflation is stable. It's like the ideal, but elusive 'price' - I'm air-quoting here - for money. If you think of an interest rate as the price for money, the lower the r-star, the cheaper the price of money necessary for that full employment and inflation balance. The higher the r-star, the more expensive the price of money. The Fed may choose to set the benchmark federal funds rate above the neutral rate to cool the economy, because that's essentially making the price of money too high relative to that balance. Or it could set the federal funds rate below the neutral rate to stimulate the economy.

Odeta Kushi - So, if you're aiming for the neutral rate, exactly, then that would be an interest rate that neither spurs growth nor slows growth. Make sense?

Mark Fleming - It makes a lot of sense, in theory, but I said it was elusive for a reason. The neutral rate isn't observable. Chairman Powell, in fact, said the neutral rate was not something we can identify with any precision. Neutral rate is one of those things that's only indirectly observable by observing how the economy, the labor market and inflation are behaving. Economists have tried to estimate r-star, but that's also proving to be an elusive challenge. Another important point to make is that the neutral rate is always discussed in real terms, that is with inflation subtracted out.

Odeta Kushi - So what are the estimates saying that the neutral rate is right now?

Mark Fleming - Well, Chairman Powell suggests that the Fed believes that r-star is currently somewhere between 2% and 3%, assuming an inflation rate of 2%. Powell insisted that the Fed is not going to hesitate to go beyond r-star, if warranted by the economic data that will come out this summer, to get rid of inflation. That's the primary objective right now of the Fed, meaning that the federal funds rate may in fact go even higher than the natural rate of inflation that we can actually observe or measure in an attempt to cool inflation.

Odeta Kushi - Well, that kind of begs the question, what was the neutral rate pre-pandemic?

Mark Fleming - Yes, a walk down history lane. We looked at the Holston Laubach-Williams estimate of the neutral rate of interest relative to the effective federal funds rate. The most recent neutral rate update was in the second quarter of 2020. No surprises here. Because of the extraordinary volatility of GDP in the pandemic. The authors have not updated their estimate since. But that data in 2020 showed that the neutral rate was at a 60-year low - 0.71% - and slightly below the federal funds rate at the time. So, yes, the real price of money was almost free. That's significantly lower than prior to the global financial crisis. And what's most interesting is that prior to the global financial crisis, r-star was consistently much higher, typically, actually somewhere between 2% and 4%. Since the mid 1970s, the very low neutral rate phenomenon is not contained to the U.S. alone. It's similar for other advanced economies, including the United Kingdom, Canada and the Euro area.

Odeta Kushi - Interesting, I wonder what's driving a persistently low neutral rate of interest?

Mark Fleming - Odeta I'm glad you asked, but we can't really know for sure. There are several factors that have been proposed - an aging population, a decline in productivity, growth, the flight to safety here in the United States, at least. Let's tackle each of them. Odeta, would you like to start?

Odeta Kushi - I'd love to. So, first, an aging population or global graying, you might be asking yourself what this has to do with the neutral rate? And the answer is that an aging population increases the old-age dependency ratio. This is the ratio of the number of older people who are generally economically inactive - so usually it is age 65 and over - compared with the number of people of working age. An aging population limits the supply of workers in an economy and reduces the output of an economy. Fewer workers to supply with capital investment means less demand for new investment, pushing down that neutral rate of interest. At the same time, increasing life expectancy in advanced economies means people are saving more in anticipation for retirement, increasing the supply of savings and also driving down that neutral rate. All right, you're next, slower productivity growth.

Mark Fleming - I feel it's like one of those, 'tag you're it.'

Odeta Kushi - Tag, you're it, exactly.

Mark Fleming - The economic expansion in the aftermath of the global financial crisis was the longest, but also the slowest in terms of cumulative GDP growth since the start of the expansion - long and slow. Similarly, productivity growth has been very slow in the aftermath of the global financial crisis as well. So, lower productivity growth means less demand for new capital investment. We just don't need as much money to apply to the worker to make them more productive, which pushes down the neutral rate of interest. And last, but not least, Odeta, tag, you're it.

Odeta Kushi - The flight to safety, so our domestic economy is more globally interconnected than ever before. And one outcome of this globally connected financial market is that when uncertainty increases globally, the demand for safe harbor assets, like U.S. Treasuries, increases. So, put another way, global uncertainty creates a flight to the safety and security of U.S. government long-term Treasury bonds, which increases the supply of capital domestically, and drives down the neutral rate of interest.

Mark Fleming - Exactly. All that capital in the U.S. drives down the price of money. Economist Alvin Hansen coined the term secular stagnation in the 1930s following the Great Depression. He used it to describe a chronic lack of investment demand relative to capital supply. Sound familiar? But in this context, secular refers to the long-term nature of the stagnation. Today, though, we use the term secular stagnation to refer to the long period of high global capital savings relative to that low demand for capital investment.

Odeta Kushi - So let me sum this up, because I think we're getting a little Econ wonky here. So global graying has resulted in excess savings, while slower productivity growth reduces demand for capital investment. The U.S. serving as a safe haven for foreign assets exacerbates the savings glut domestically, and the result, the price of money or the neutral rate of interest is low because the economy is in a new era of secular stagnation.

Mark Fleming - Yes, but, Odeta, there's also some new research from a Fed working paper entitled 'The neutral rate of interest through a hall of mirrors,' - I'll explain in a second - which implies that the decline in the neutral rate of interest reflects not the demographic savings and capital factors that we just described, but rather a hall of mirrors - an effect in which lower policy rates change private sector behavior in ways that lower r-star. Essentially, the Fed and the private sector are each reacting to each other's moves and interpreting each other's expectations of what they think the other believes the elusive r-star to be. And what happens when you put these mirrors facing each other is the reflection keeps bouncing back and forth, a hall of mirrors. This would have very different policy implications than the reasons we previously cited. The demographic savings and capital explanations for a lower neutral rate cannot be changed easily by policymakers. So r-star is not really in the control to be set by policymakers. But a hall of mirrors explanation, on the other hand, may allow for a change by signaling a clear expectation to the private sector. So the elusive r-star is that much more uncertain now, because we're not even sure how it really operates.

Odeta Kushi - So getting back to why this all matters, or I guess, does it even matter?

Mark Fleming - Well, that's a great question, because this is really wonky economics. But recall that Chairman Powell, in his press conference, said that the neutral rate of interest is between 2% and 3%, with a wide margin of uncertainty, and they're using that as a target for how they're going to do their federal funds rate moves. In other words, they're not really sure how high is too high. Rates will likely there go there this year, according to the Fed dot plot explanations and all the telegraphing that they're doing. But will it be enough? And since we're housing economists, we have to ask the question, what's the implication for the housing market? Tighter monetary policy is an indication that the Fed is trying to cool things down, including the housing market. Some more aggressive rate hikes certainly and aggressive quantitative uneasing which was also announced at that meeting a couple of weeks ago, could put more upward pressure on mortgage rates and cool housing demand. That's the affordability effect that we talk about that all the time. But there is another.

Odeta Kushi - Yes, there is. It's no surprise that rising rates reduce affordability, as you mentioned, but they also keep homeowners rate locked-in. The difference between the prevailing mortgage rate, which is currently over 5%, and the outstanding rate, that's the average of all outstanding mortgages, is a proxy for the extent to which homeowners are rate locked-in. The more positive the difference, the more borrowers have better rates on their mortgage than the market rate. That means the more the lock-in effect, so the more owners are rate locked-in, the less likely to sell and then buy, and that means fewer sales.

Mark Fleming - Great point, rising rates may cool demand, but they may also crimp supply. That's some tricky business. But will getting the Feds fund rate to, or above, that elusive neutral rate be enough?

Odeta Kushi - That really depends on inflation. If inflation remains higher, than the neutral rate will also need to be higher. Pinning down that neutral rate of interest is really difficult in a normal year, but it's even more of a moving target in such an uncertain year. And Powell has been clear, he remains data-dependent and will raise the federal funds rate as far as it needs to go to get us to stable inflation.

Mark Fleming - So maybe r-star isn't the monetary policy north star after all, maybe it's inflation.

Odeta Kushi - Yeah, maybe. All right. Well, that's it for today's episode. We love an opportunity to get Econ wonky on this podcast, and we hope that you enjoyed it as well. Thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.

This transcript has been edited for clarity.