There’s not much suspense around this week’s Fed meeting: the fed funds target rate is almost certain to rise by 25 basis points. We think it’s more important not to overlook this cycle’s endgame.
As the Federal Open Market Committee (FOMC) meeting kicks off, the market is pricing in a 96% probability of a quarter-point hike in the official short-term rate. With that outcome nearly certain, most of the speculation is focused on the path of the fed funds rate—specifically, the “dot plot” that signals the committee’s rate expectations—for the rest of 2018.
We think the intense focus on the near-term dots is misplaced. Whether the committee raises rates four times this year (our longstanding forecast) or three times really isn’t economically significant. What is significant is where the committee ends this rate cycle.
Two key concepts come into play here: the neutral rate and the terminal rate.
The Neutral Rate: Monetary Policy’s Sweet Spot
The neutral interest rate is the rate at which monetary policy is neither accommodative nor restrictive. In other words, it isn’t boosting growth and isn’t slowing it down. Think of it as an equilibrium rate; what would the fed funds rate be if growth and inflation were both at their natural rate on a stable basis?
Each quarter, the FOMC forecasts this interest rate, known as the long-run fed funds rate. Over the last few years, the Fed has reduced this estimate sharply, from 4% when the first set of forecasts was released to the current 2.8%.
Why has the neutral rate come down? Mainly because potential economic growth rates are declining as American society ages. But there’s also a cyclical element pulling the neutral rate down: the interest rate that the economy can withstand is lower when growth is slower.
Some analysts think the cyclical component will push the neutral-rate estimate up as the economy improves. This would signal the market that there’s more room to hike rates in the next few years than is currently expected. We don’t think the FOMC is ready to bump the neutral rate up yet, but even so, the market could be underestimating where rates will end up this cycle—a.k.a. the terminal rate.