How high will policy rates go?

The monetary policy outlook has changed dramatically in the last six months or so. Central banks are hiking, and markets are pricing in (a lot) more to come from many major central banks.

Pinning down how high interest rates will rise this cycle (terminal rates) is difficult and feels like a moving target in an environment where inflation keeps surprising on the upside. With fears of recession rising alongside interest rates, it is also worth pondering how long it might be before we see central banks having to cut rates again.

Neutral rates help shape expectations of how far central banks will hike 

The neutral (or natural or equilibrium) policy interest rate is the interest rate that, if the economy starts from a position with no output gap and inflation at the target, would sustain output at potential and inflation at the target. It is normally defined in real terms as r*. With inflation currently well above central bank targets and unemployment at very low levels, arguably central banks should be trying to get to at least neutral and quickly.

Neutral rates are probably still not very high, but are higher

Relatively low neutral rates in recent years have been supported by a range of factors including demographics, debt levels, and risk attitudes. My estimates of a medium-term nominal equilibrium/neutral interest rate (r* plus the inflation target) are currently (only) around 2.25% in the US and UK and 2.0% in the Euro area, arrived at by averaging several different methodologies/sources. These have been revised up in recent months though as market implied future policy rates have risen (one of the sources used in my estimates).

Neutral not that helpful though

Most awkwardly, neutral rates are not even observable. Economists take different approaches to estimating neutral rates (and come up with different numbers). Different concepts appear in the literature too, including, crudely, a long and shorter-run definition. If the underlying structure of the economy is uncertain – as arguably it is at the moment in the wake of the pandemic – then any estimates maybe even less useful than usual.

Still some distance from terminal rates

How far policymakers may need to raise interest rates above neutral to get inflation sustainably back to target is a difficult question to answer. With inflation expectations and inflation so far above target, the direction of risk is for significantly higher than neutral interest rates.

The Federal Reserve (Fed) funds heading for 10%...?

Using simple rules has merit, especially when the underlying structural fundamentals of the economy are somewhat unclear: Focusing on the UK and US and mapping policy rates against a weighted sum of how fair the unemployment rate is below the non-accelerating inflation rate of unemployment (NAIRU) (using external estimates) and how far above target core inflation is, both UK and US interest rates should be significantly higher than they are at present and that is a conclusion relatively resilient to different changes in weights (reflective of just how low unemployment is and how high inflation is).

…Probably not: Simple rules are too simple

Several factors are likely to mean we don’t regain pre-GFC levels of nominal policy interest rates, let alone a double-digit Fed Funds rate. First, there is relatively widespread agreement that neutral rates are lower than they were 20 years ago. Further:

• Inflation is likely to fall later this year, also reducing the risk of further increases in inflation expectations and potentially helping them fall somewhat.
• Cost of living squeeze may do some of the work of central banks: Households and firms in many developed economies are out of practice with living in a high inflation environment and seeing big jumps in the level of prices. With low levels of wage indexation and unionisation, employees can’t assume that wage growth will compensate. With wage growth not keeping up with inflation and likely expectations that that will remain the case, consumers are likely to rein in their purchases. That (alongside the effect of already higher market interest rates on housing activity and fixed investment) should help dampen demand growth and may lead to some increase in the unemployment rate.
• QT means fewer rate hikes needed: As central banks switch from quantitative easing (QE) to quantitative tightening (QT), central bank balance sheet reduction can also play a role in tightening financial conditions and therefore partly offset the need for some interest rate increases in some economies.

How long until we need to start thinking about rate cuts?

If interest rates get above neutral rates and into restrictive territory, then as inflation comes back under control you’d expect those rates to return to neutral. It was notable that the median Fed participant forecast last week was consistent with rates being cut in 2024. If central banks end up pushing economies into significant downturns, sooner or later we’ll be in sharp rate cutting territory again. Domash and Summers in their recent paper [1] suggest that in the case of the US at least, it is effectively implausible for the Fed to engineer a soft landing – that the labour market is already too tight for a benign outcome.

Revising up my interest rate forecasts again

The European Central Bank (ECB) and Fed have become more hawkish more quickly than I’d expected (the Bank of England (BoE) have sent mixed and ambiguous messages on the rate path ahead). Alongside my slightly higher estimates of neutral, stronger than expected recent inflation and inflation expectations outcomes, I am revising up my central bank projections for the three central banks again. Fed policy makers are openly saying that they want to go above neutral which they arguably see as 2.5% (using Fed participants’ median long-run policy rate forecast as a proxy).

Generally, the new forecasts get interest rates close to neutral more quickly, including hikes into restrictive territory, peaking at 3.75% in early 2023 in the case of the Fed.

The direction of risk for the BoE and ECB is that they end up looking more Fed-like, i.e., with rates advancing further and quickly into restrictive territory. The consumer support coming from fiscal policy makes that outcome more likely. To an extent, the BoE and ECB can ‘free ride’ off the US. If the Fed manage to moderate US demand that could be very helpful for reducing global inflationary pressure, e.g., by easing supply chain stresses. However, a widening rate differential could also translate into more currency depreciation – and therefore inflationary pressure - in the UK and Euro area.

*Upper end of Fed Funds target range; **Refi rate
Source: Central Bank websites (current policy rate); RLAM forecasts

Additional information

1. A labor market view on the risks of a U.S. hard landing | NBER

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