Are official interest rates accurate?

At the beginning of 2024, encouraged by dovish comments from several of the world’s leading central bankers, many investors expected a rapid fall in official interest rates, led by the US Federal Reserve and beginning as early as March. Indeed, the consensus expectation for the US was that there would be as many as six cuts during the year. Clearly, that has not turned out to be the case and even though we were never in that camp, it is important to consider what path might lie ahead for interest rates from here and how markets might respond.

The first thing to remember is that there are many different interest rates and they each have a role to play in the economy. These include official rates (set by central banks); long term government rates (set by markets); US rates; European rates; UK rates; mortgage rates; swap rates etc. Each of these themselves can be either nominal rates or real (adjusted for inflation) rates. There are even some interest rates that can’t be seen but are very important to policy makers, such as the “neutral” rate. That is the rate at which official rates have neither a stimulative nor restrictive effect on the economy.  If that weren’t confusing enough, the level of different rates may send a different message to investors as to what is going on in the economy now and what the combination of rates implies for the future. 

Official rates are set by central banks as part of their monetary policy in order to influence activity in the economy via, among other things, changes in the behaviour of economic actors and market-determined interest rates. This is a bit like taking a dog for a walk. Depending on the authority (credibility) of the walker, the dog may either follow along at the same pace and go exactly where it is expected to, or it might anticipate where it thinks it is going and start pulling on the lead to get there more quickly. If it is off the lead (e.g. a completely free market dog), then it might get distracted by something and go off in an entirely different direction and require quite a bit of persuasion to come back!

At present, central bankers and investors are trying to determine whether the current level of official rates (e.g. the Federal Funds rate in the US) is either too restrictive (likely to slow economic growth and increase unemployment), too stimulative (likely to boost economic growth and increase inflation) or about right (i.e. the aforementioned “neutral” level of rates). As we mentioned at the start of this note, investors have, for much of the past several months, viewed rates as being more restrictive than needed to bring the level of inflation down to the targeted rate of 2%. That is why they have expected more cuts in the Fed Funds rate than has happened and it is also why longer term (e.g. 10-year) government bond yields have been, and remain, lower than shorter term rates. Of course, investors prefer lower rates and so that may be why they are more inclined to see current policy as being too restrictive. Central banks, on the other hand, must be credible and so have a tendency to be cautious before signalling that the direction of interest rates has changed, not least because a resurgence in inflation expectations is a very difficult dog to get back.

That is why an estimate of the neutral rate is so important. Neel Kashkari, the President of the Federal Reserve Bank of Minneapolis (one of the regional Federal Reserve Banks in the US central banking system) has discussed this topic in a series of articles over the past couple of years. In summary, he argues that real (inflation adjusted rates) are best when trying to find the “neutral” rate. Using Treasury Inflation Protected Securities (TIPS) as his guide to what real rates have been in the past, he estimates that a 10-year real rate of zero percent is what had been the neutral rate over the years leading up to the COVID-19 pandemic. In order to stem the inflationary pressures resulting from that, the Federal Reserve has raised rates such that the real rate on TIPS has risen to almost 2%. In the context of the pre-pandemic world, that implies policy has become significantly restrictive. However, while arguing that he believes the “neutral” rate is probably still zero percent in the long run, it may have risen temporarily and so policy may not be as restrictive as might seem. Central bankers, as we noted above tend to be cautious and do not want to take the chance that inflation simply settles at a higher rate than their target, even if many investors might say that they would not worry if inflation turned out to be 3% rather than 2%.

Our view has, for some time, been that the “neutral” rate will settle around 1% and that inflation for some period will remain slightly above the 2% target that many central banks have. So, assuming inflation of 2.5%-3.5% means that 10-year bond yields of 4% should not be a surprise. Even if central banks reduce short term rates a little, the yield curve is likely to steepen (longer rates return to being higher than short rates) suggesting that there is little scope for long term rates to fall significantly from current levels. However, this should not be seen as a negative scenario. The economic world is simply returning to a more normal state where money has a positive cost and investment decisions by individuals, companies, institutions and perhaps even governments can be made on a more rational basis.