Stargazing: The quest for a new neutral rate

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

• Despite several geopolitical flashpoints, bond investors have two questions on their mind this year: can rates go higher and how low will they be once central banks cut them?
• As  headline inflation eases and approaches its target, rates appear unlikely to climb in 2024. Indeed, forward rate markets have already pencilled in deep cuts
• The so-called neutral rate is used in informing longer-term monetary policy. It is often crucial to the ultimate destination for rates
• Our in-depth analysis suggests that the federal funds rate could eventually target a range between 2% and 3%, which means that the window to lock-in yields is still open but closing fast

A tumultuous second and third quarter in 2023, which saw US 10-year bond yields surge to 5% and led UK equivalents to advance to 4.87%, helped to make it a positive year for global bonds. The late rally meant US investment grade corporate bonds return 8.3% on average, while sterling- and euro-denominated bonds performed 10% and 8.8% respectively in 2023. 

At the onset of 2024, bond investors have to answer two questions this year: can rates go any higher? And where will rates stand once the US Federal Reserve (Fed), Bank of England and European Central Bank ease their currently restrictive level of rates? 

Higher rates seem to have become less likely, at least when it comes to policy rates. Inflation has moderated notably, from the peaks seen last year, with headline inflation now at 3.4% in the US, 4% in the UK and as low as 2.9% in the eurozone, leaving room for policy easing. Indeed, forward-rate markets imply a fed policy rate of 4.5% by July this year, and 4.7% and 3.1% in the UK and eurozone, respectively. 

Bond market navigation by the r-star 

The rather short-term market-implied policy rates are complemented by the so-called neutral rate. This theoretical measure estimates the policy rate that keeps an economy at its equilibrium. In reality, economies are always at the mercy of the economic cycle (compromising such an equilibrium).

While this theoretical rate does not help to predict a central bank’s next step, it is a guiding factor for long-term monetary policy and as long as central banks use such a rate in their communications and decision-making, it has market relevance. 

Finding the right r-star

There are many approaches to estimating the neutral rate. The most well-known technique is to apply a statistical filter that blends out the cyclical noise and extracts the unobservable neutral rate. In addition, this method detects the unobservable growth potential from data that is subject to the economic cycle, such as growth, inflation or interest rates.  

The above is the approach suggested by the Holston-Laubach-Williams (HLW) model, which is published by the New York Federal Reserve¹. Another, less statistical but more structural approach is to derive the compensation a household will demand for its savings². This very structural approach leans on estimates of long-term economic growth, population growth and some assumptions on preferences for consuming today rather than tomorrow.

A third approach is to consider central banks or markets for guidance. The Fed expects the neutral rate to be 2.5% on a nominal basis, which translates into a real neutral, or r-star, rate of 0.5%, based on an inflation rate of 2%.  

To extract the market’s estimate for r-star, one has to look far out in the rates market, to where prices are less likely to be influenced by the current economic cycle. A common approach is to treat the one-year rate in five years’ time to estimate the neutral rate.

Charting neutral-rate phases 

The chart below shows the nominal neutral rate estimates of the above approaches over time (including a forecast from our own framework). The decline in the rate from 2000 to 2008 reflects the moderation phase that started in around 1980, one that can be explained by slower population growth and weaker economic growth. 

From 2010 onwards, the structural estimates have started to increase again, not because demographics have improved, but because growth has been resilient due to reasons such as expansionary fiscal and monetary policy. 

Nominal neutral rates on the rise

Trends in three models that estimate the nominal neutral rate show that the rate has risen since 2010, after three decades of heading lower 

Neutral rate likely between 2% and 3%

Looking across the estimates for the neutral rate, the federal funds rate could be heading to an eventual target in the range between 2% and 3%. Interestingly, today’s estimates are not too different from those of 2019, before the onset of the pandemic, when the US rate sat just within this range. 

Turning to the market-derived estimate (such as the five-year ahead one-year forward rates), much has changed, especially in the realm of inflation expectations. The more structural estimates take a more cool-headed approach and offset the prospect of a further weakening in demographics, with the potential advantages of technological advances, such as the integration of artificial intelligence. 

Our assessment of important drivers of the neutral rate and their effect are summarised in the table below³. 

Expected effect on neutral rate

Estimated likely impact of changes in technology, public debt levels, savings rates, population growth and economic inequality on the neutral rate 

The neutral rate remains an intangible construct. The Fed and other central banks, however, need such a construct to navigate around cycles over the longer term. Consequently, it cannot be ignored entirely. The period of a downward trending neutral rate may be over, but it is unlikely to be several percentage points above what has been estimated recently: around 2.5% in the US. 

This, and the prospects of a cooling global economy, provides still some room for lower yields. Consequently, the window to lock-in rates remains open, but not for a very long time.

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