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Stocks have soared since the election, while bonds have been caught in a tug-of-war between bulls and bears, with participants in both markets trying to determine the path of the US economy under the incoming Trump administration.
At the heart of the matter lies a hotly debated issue that has both Fed economists and Wall Street in its grip. Something that, like the mythical yeti, no one has ever seen, but everyone agrees exists: the neutral rate.
Kathy Jones, chief fixed income strategist at Schwab, recently joined Yahoo Finance’s Stocks in Translation podcast and described neutral rates as “the Sasquatch of the financial world.”
The neutral rate is simple enough 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 stagnates.
The problem is that no one really knows precisely which interest level meets this high standard.
“You model its input by looking at the past,” Jones said. “Things like productivity can be involved.” She noted that if workers can increase their productivity and production, the economy can grow – crucially, without inflation.
Minneapolis Fed Chairman Neel Kashkari recently reiterated this 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 cut until the economy returns to neutral.
Nevertheless, this vague interest rate is critical in shaping Federal Reserve policy.
At Invest, Kashkari echoed Fed Chairman Jerome Powell’s words at the FOMC press conference in September: “The neutral rate is not directly observable. We know it by its effect on the economy.”
With the Fed currently in the process of cutting 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 argue for more aggressive cuts.
Recently, investors have come around to the idea of a higher neutral interest rate.
When the Fed began its rate-cutting cycle in September, investors expected the Fed to cut short-term interest rates to 2.8% by the end of 2025 – or a range of 2.75% to 3%. Six weeks later, the bond market is now priced at four fewer interest rate cuts – bringing expected interest rates next year to a range of 3.75%-4%.
