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While stocks have soared since the election, bonds have been caught in a tug-of-war between bulls and bears, with participants in both markets trying to predict the future of the U.S. economy under the incoming Trump administration.
At the heart of the matter lies a hotly debated topic that fascinates both Fed economists and Wall Street alike. Like the mythical yeti, there is something that no one has ever seen but everyone acknowledges exists: the neutral rate.
Cathy Jones, Schwab’s chief fixed income strategist, recently appeared on Yahoo Finance’s “Stock in Translation” podcast and described neutral rates as “the Sasquatch of finance.”
Defining the neutral interest rate is very simple. Interest rates neither stimulate nor slow down the economy. That’s the sweet spot where growth and inflation are balanced. Too low and the economy can overheat. Too high and growth will stagnate.
The problem is that no one knows exactly what interest rate levels meet this high standard.
“We look at the past and model that input,” Jones said. “Things like productivity may be taken into account.” He said if workers can be more productive and produce more, importantly, they can grow the economy without causing inflation. he pointed out.
Minneapolis Fed President Neel Kashkari recently made similar remarks at the Yahoo Finance Invest 2024 event, explaining that “in a high productivity environment, the neutral rate should be higher.” He said that if productivity is structurally strong, the Fed will have less room to cut rates until the economy returns to neutrality.
Nevertheless, this nebulous interest rate is extremely important in shaping Federal Reserve policy.
Invest’s Kashkari echoed Fed Chairman Jerome Powell’s words at the FOMC’s September press conference, saying, “The neutral rate is not directly observable. We know that because of its impact on the economy.” .
The Fed is currently cutting interest rates, and a higher neutral rate means the Fed doesn’t have to cut rates as much to support the economy. Alternatively, a lower neutral rate would require more aggressive rate cuts.
Recently, investors have begun to embrace the idea of higher neutral interest rates.
When the Fed began its rate-cutting cycle in September, investors expected the Fed to cut short-term interest rates by 2.8%, or in a range of 2.75% to 3%, by the end of 2025. Six weeks later, the bond market is now pricing in four fewer rate cuts, with expected rates next year in the range of 3.75% to 4%.
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