The Fed’s 50 basis point rate cut at its last meeting surprised analysts. However, the real interest rate remains above the natural real rate. Therefore, we can expect further, but gradual, cuts in the near future.
The Fed’s Choice
The monetary policy decision that the Fed took at its last meeting was far from obvious. It had, in principle, possible costs and benefits. Reducing the cost of money too much would have meant stimulating an economy that in any case remains robust, risking pushing inflation up again. Reducing the interest rate too little would have meant remaining, as they say in jargon, “behind the curve”, that is, lagging behind the trend of inflation that has been declining for some time now.
The US central bank has therefore surprised the markets with a 50 basis point cut in interest rates, more than expected. Did it do so because it believes that the real economy (the labor market) is actually starting a slowdown? Or because it believes that credit conditions are now too restrictive in the face of an inflation rate that has now been falling for several quarters? Doubts remain.
In general, is it possible to judge more rigorously whether the Fed’s monetary policy is now too restrictive or too expansionary? Is it possible to understand whether today’s substantial reduction in interest rates is the first step on a downward path toward a “normalization” of monetary policy? And what does it mean, if anything, that interest rates, the primary instrument of monetary policy, have reached a “normal” level?
How the natural interest rate is constructed
A rigorous answer to this question can be provided by introducing the concept of the natural (or neutral) real interest rate. It is the interest rate such that the aggregate output of the economy is in line with its long-run potential value and simultaneously inflation is not stimulated either upwards or downwards. In other words, a “normal” monetary policy is one that neither stimulates the economy above potential (generating inflation) nor contracts it below potential (pushing inflation downwards).
It should be immediately clarified that the natural real interest rate is not directly observable in the data. It is a measure consistent with some ideal conditions prevailing in the economy, and therefore it can only be estimated starting from a stylized macroeconomic model of the economy as a whole. Furthermore, it is a target to which monetary policy adjusts gradually, and not instantaneously, so that the effective real interest rate coincides with the natural rate only on average.
An estimate of the natural real interest rate can be constructed from the Holston-Laubach-Williams (HLS) macroeconomic model, the details of which are described in the database of the Federal Reserve Bank di New York.
Figure 1 reports some relevant measures of interest rates in the US during the recent period of growth and subsequent decline in inflation (blue line). The orange line shows the nominal interest rate, formally the Federal Funds Rate, i.e. the interest rate at which banks exchange overnight loans, set by monetary policy. It is precisely on this interest rate that the Fed makes its policy decisions. The gray line describes the real interest rate, i.e. the nominal interest rate net of inflation. This adjustment to the inflation rate is of crucial importance. It is only the real interest rate, in fact, that represents the true measure of the cost of money and credit that influences the consumption and investment decisions of households and firms. Finally, the red line indicates the estimate of the natural real interest rate, according to the Hls procedure. It is clear that this measure of the real rate maintains much more stability over time, because it reflects deeper movements in the fundamental values of the economy.
The value of the natural real rate is the theoretical compass of reference for judging whether, at any given moment in time, the Fed’s monetary policy is excessively restrictive or expansionary. A real interest rate above the natural rate indicates that monetary policy is still too restrictive, while a real rate below the natural rate signals a monetary policy that is too expansionary. From this point of view, economic theory therefore helps to establish a rigorous and objective reference value for judging the state of monetary policy, beyond the endless journalistic discussions that judge the interest rates set by the central bank to be too high or too low on the basis of mere qualitative considerations.
What will happen tomorrow?
The figure suggests some important insights. First, the development of the real interest rate (grey line), which is the correct measure of the degree of monetary and financial constraint applied by the central bank to the economy. Despite the gradual increase in the policy rate (nominal rate, orange line) starting from April 2022, the real rate remained negative for a long time. This was because the nominal rate did not compensate for the rapid rise in inflation. For a long time, therefore, real credit conditions remained expansionary, even though the Fed was adjusting the nominal policy rate upwards to combat the rise in inflation. It is only in mid-2023 that the real interest rate becomes positive and only shortly thereafter does it exceed the natural real interest rate (yellow line). In other words, monetary policy becomes formally restrictive (real rate above the natural rate) only about a year after inflation peaks. This demonstrates the delays with which central banks typically manage to exert their effects on the economy and inflation.
A second important point concerns the current state of monetary policy. Returning to the comparison between the real interest rate and the natural rate, we can see that the former still remains decidedly above the latter. The Fed’s monetary policy conditions, therefore, remain formally and largely restrictive today. Before the latest cut, the real interest rate was at around 2.75 percentage points, while the neutral rate was at around 0.74 percentage points. There is clearly plenty of room before reaching a normalization of monetary policy.
This helps to understand the Fed’s recent decision. Given the still existing gap between the real interest rate and the natural real rate, a 0.50 percentage point decrease in the policy rate, which surprised many analysts, actually appears not so excessive.
The natural rate is a reference to which monetary policy tends “on average”, not instantly. It follows that in the near future we must expect new decreases, but only gradual ones, to drive the real rate in line with the ideal reference value of the real natural rate. Only then will we have, in a technical sense, a definitive normalization of monetary policy.
The voice belongs to everyone: support it!
Lavoce.info does not host advertising and, unlike many other news sites, access to our articles is completely free. The commitment of the editors is voluntary, but donations are essential to support the costs of our site. Your contribution would strengthen our independence and help us improve our offer of free, professional and free information. Thank you for your help!
