A Not So Neutral Rate

by: economist88

Monetary policy decisions are sometimes rule based. When using a basic Taylor rule equation, the NAIRU, the natural rate and the output gap determine the "neutral" policy rate. Although Taylor rule is a policy rate prescription, much of Fed policy is nowadays driven by second derivative versions of the Taylor rule like "optimal control". This model favored by Yellen, Evans, Bernanke and describes a glide path for the policy rate under different economic assumptions. For investors there is an important message. Despite a "gangbusters" real GDP of 4% in Q3 and Q4 2013, the optimal control model says Fed Funds is likely not to be hiked by late 2016, perhaps even until 2017. Under that assumption, investors have to look at another variable that has entered the monetary policy equation. This is the "term premium". It is the extra return investors demand for buying long maturity bonds instead of rolling over a strip of short-term bonds. In his speech from March last year, Bernanke mentioned the term premium turned negative as of 2011 because investors driven by high uncertainty sought the safety of long-term bonds. A negative term premium would presumably mean that investors in theory would make no tradeoff between holding short-term or long term securities. In reality such a trade off is strongly influenced by what investors expect the short-term interest rate to be in the future.

The traditional Taylor rule has been prescribing a 0.5%-0.75% Fed Funds rate since the summer of 2011. This would be based on a natural real rate of 2% and NAIRU closer to 6%. That path of interest rate hikes has been rejected by the Fed and other central banks based on their view of the economy experiencing "slack". That meant the term premium was negative because slack results into low inflation. Investors would therefore demand less risk premium in long maturity bonds. By May 22nd however, something changed. The term premium turned decisively positive, currently estimated to be +0.85% by various models such as those of Kim-Wright. The positive term premium suggests investors demand premium for holding long maturity bonds, not only because of risk of higher inflation but also because of the change in the path of expected short-term rates. The theory of the interest rate term structure says a bundle of expected short-term rates equals the long-term interest rates all else being equal. Because of a change in the term premium, investors also changed their view on the future path of Fed Funds. It has set in motion an expectation of 'normalization' of long-term interest rates. Ultimately this is what the Fed wants judging from the Fed's forecasts of the long run neutral rate at a 3.95% median in December.

With a steep yield curve and positive term premium, this started a debate among economists (Summers, Krugman, et al) whether the natural real rate is negative or positive. The natural real rate is not observable and perhaps easiest to estimate by taking the sum of productivity and population growth. For the US, both are about 2% annually, suggesting also a 4% natural real rate. There is then one last variable investors look at which is medium term inflation expectations. The latest Michigan release shows 5-10yr inflation expectations around 2.8%. For a fixed income investor there are a few conclusions to be drawn from all these numbers. A yield of bond could be seen as the summation of expected inflation, an expected short-term rate and the term premium. The yield comprises out of a short-term expected rate (say Fed Funds at 0.25% by 2017), expected inflation (2.8% for next 10-years) and a term premium (0.85%). The expected yield of a long maturity bond would be 3.9%, close to the Fed's forecast of the long run neutral rate at 3.95%.

So eventually longer term rates will "normalize" but to not have this change become too disorderly, the Fed (and other central banks) are likely to further strengthen their "forward guidance". Stronger forward guidance continues to provide a very steep yield curve for fixed income investors. Whether an investors likes shorter maturities (1-5yr) or medium term securities (7-10yr), the slope of the yield curve is a 'stable' source of return. For instance when investing in a 5-year Treasury bond yielding 1.65%% that rolls down the yield to a 4-year Treasury yielding 20 basis points lower, the investor can 'pocket' the 20bps difference because the policy rate is likely to remain on hold during that 1-year holding period. Because the difference between the 5-year yield and Fed Funds is 1.45% (or 145bps), known as 'carry', is the other component of return a fixed income investor can earn. Together this is not a bad return given stock markets at record highs, the Fed scaling back quantitative easing but holding Fed Funds at 0.25%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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