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Stocks have risen since the election, while bonds are caught in a tug-of-war between bulls and bears, and participants in both markets are trying to guess the direction of the U.S. economy under the incoming Trump administration.
At the heart of the matter is a hotly debated issue that worries both Fed economists and Wall Street. Something that, like the mythical yeti, no one has ever seen but everyone agrees exists: the neutral type.
Kathy Jones, chief fixed income strategist at Schwab, recently joined Yahoo Finance’s Stocks in Translation podcast and described the neutral rate as “the Sasquatch of the financial world.”
The neutral rate is quite simple to define. It is the interest rate that neither stimulates nor slows down the economy. It is the sweet spot where growth and inflation are in balance. Too low and the economy could overheat; too high and growth stops.
The problem is that no one really knows. precisely what level of interest rates meets this high standard.
“Their contributions are shaped by looking back,” Jones said. “Things like productivity could play a role.” He noted that if workers can increase their productivity and increase their output, the economy can grow, crucially, without inflation.
Minneapolis Federal Reserve President Neel Kashkari echoed this recently at the Yahoo Finance Invest 2024 event, explaining: “In a higher productivity environment, the neutral rate should be higher.” He said that if productivity is structurally higher, the Fed has less room to make cuts until the economy returns to neutral.
However, this nebulous rate is critical in shaping Federal Reserve policy.
At Invest, Kashkari echoed Federal Reserve Chair Jerome Powell’s words at the September FOMC press conference, saying: “The neutral rate is not directly observable. We know it by its effect on the economy.” .
With the Federal Reserve currently in the process of lowering rates, a higher neutral rate implies that the Fed does not need to cut rates as much to support the economy. Alternatively, a lower neutral rate would be an argument for more aggressive cuts.
Lately, investors have begun to accept the idea of a higher neutral rate.
When the Federal Reserve began its rate-cutting cycle in September, investors expected the Fed to cut short-term rates to 2.8% (or a range of 2.75% to 3%) by the end of 2025. Six weeks later, the bond market is now priced at four less rate cuts, bringing the projected rate next year to a range of 3.75%-4%.
