Fed Chair Jerome Powell announced months ago that he wants the fed funds rate to eventually stabilize at the “neutral rate,” which neither slows nor stimulates the economy. This is a far cry from the past 20 years of Fed policy which was highly stimulative for long periods of time.
The asset markets became addicted to negative real yields which supported historically high prices of stocks, bonds and real estate. The markets have understood the Fed’s policy of combating inflation with elevated interest rates but they expect this to be temporary. Many market players may never have experienced anything but negative real yields. If the Fed never returns to negative yields but holds the fed funds rate at a neutral level for the long term…the markets may reprice lower after a time of disbelief.
Nick Timiraos is the WSJ’s “Fed whisperer” who often has an inside track to Fed policy.
Higher productivity and increased deficits could raise the ‘neutral’ rate of interest, limiting Fed cuts
By Nick Timiraos, The Wall Street Journal, Aug. 20, 2023
Despite the Federal Reserve’s raising interest rates to a 22-year high, the economy remains surprisingly resilient, with estimates putting third-quarter growth on pace to easily exceed its 2% trend. It is one of the factors leading some economists to question whether rates will ever return to the lower levels that prevailed before 2020 even if inflation returns to the Fed’s 2% target over the next few years.
At issue is what is known as the neutral rate of interest. It is the rate at which the demand and supply of savings is in equilibrium, leading to stable economic growth and inflation…
Last December, Jerome Powell said the Fed would be careful about fine-tuning interest rates based on estimates of the neutral rate — for example, because falling inflation pushes real rates well above neutral. “I don’t see us as having a really clear and precise understanding of what the neutral rate is and what real rates are,” Powell said… [end quote]
There are plenty of arguments for both a higher and lower neutral rate. The Fed plans to play it by ear, depending on the inflation rate and GDP growth.
Currently, the Fed is working its plan of monetary restriction. The fed funds rate was raised to 5.25% - 5.5% and the market expects this to hold (or perhaps be raised 0.25%) throughout 2023. The Fed has been gradually rolling off its immense book of longer-term Treasuries and mortgage backed securities.
At the same time, large government deficits are providing fiscal stimulus.
The stock and bond markets both fell in August. (Bond prices fall when interest rates rise.) The Fear & Greed Index subsided to Neutral. It’s too early to say whether the stock market slump is a trend change or just noise. The bond market drop may be temporary depending on the strength of the economy.
The trade is mildly risk-off. Gold, silver and copper fell. The USD and oil rose.
Beijing wanted to cool its housing market, but created a bigger problem, as the fallout from debt-laden developers and sinking sales spreads to the broader economy.
The economic model that took the country from poverty to great-power status seems broken, and everywhere are signs of distress
Many previous predictions of China’s economic undoing have missed the mark. China’s burgeoning electric-vehicle and renewable energy industries are reminders of its capacity to dominate markets. Tensions with the U.S. could galvanize China to accelerate innovations in technologies such as artificial intelligence and semiconductors, unlocking new avenues of growth. And Beijing still has levers to pull to stimulate growth if it chooses, such as by expanding fiscal spending.
Even so, economists widely believe that China has entered a more challenging period, in which previous methods of boosting growth yield diminishing returns. …
China’s national income per person reached about $12,850 last year, below the current threshold of $13,845 that the World Bank classifies as the minimum for a “high-income” country. Japan’s per capita national income in 2022 was about $42,440, and the U.S.’s was about $76,400. …
It’s hard to say whether Chinese economic weakness is impacting the U.S. stock market, which is still very overvalued though slightly lower than its recent bubble high.
The METAR for next week is partly cloudy. The markets may drop slightly but there’s no crisis on the horizon. The economy is strong. The Fed is holding steady. The drop may be noise. On the other hand, the recession predictors are still in place. I’m still waiting for the other shoe to drop. But probably not next week.