The Fed is trying to tighten financial conditions to cool down inflation, and they do this by raising the Fed funds rate. And the Fed’s models find that the neutral Fed funds rate where monetary policy is neither accommodative nor restrictive is when the Fed funds rate is 2.5%, which is where the Fed funds rate is today. Last week, the Fed argued that with the Fed funds rate now at neutral, they would drop forward guidance and instead be flexible meeting-by-meeting.
The analytical challenge is that the models estimating r-star, or the neutral Fed funds rate, only include one interest rate, namely the Fed funds rate, and don’t include the true costs of capital for firms and costs of borrowing for households such as the yields on IG, HY, and loans, and also the level of the S&P500 for companies, and the costs of borrowing on auto loans and credit cards and mortgages.
Put differently, the Fed funds rate can be at 2.5% and S&P500 at 3000, and HY spreads at 10%, and this would probably not be considered neutral.
Similarly, the Fed funds rate at 2.5%, S&P500 at 5000, and HY spreads of 3% would probably be regarded as easy financial conditions.
The bottom line is that the assumptions going into the academic models estimating the neutral Fed funds rate are simply too far away from the real world to make their estimates of r-star useful. With equities and credit now rallying, the bottom line is that the true r-star is higher, which is a different way of saying that to successfully cool the economy down, the Fed will likely have to raise rates more than the market is currently pricing.
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