The most important message for economists from the Federal Reserve last week was the lowering of rate-setters' long-run forecast for interest rates. Fed policy makers dropped their average prediction for long-run interest rates from 3% to 2.8%, implying that if the economy were working perfectly, rates wouldn't need to be so high to stop inflation taking off.
That should be great news for Treasurys, right? Lower yields mean higher prices, after all. Yet, investors seem to have ignored the change. Traders focused instead on the prediction of another hike this year. The mini-reflation trade that was already under way has accelerated, helped by rising hopes of tax cuts. Bond yields have risen, which shareholders took as a cue to rotate out of the soar-away technology stocks into weaker sectors more likely to benefit from a stronger economy.
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What's known as the long-run neutral rate of interest, the natural rate, or "r*," has a big influence on how policy makers set rates. It's the rate that should keep inflation steady when the economy is running at full capacity, and is key to judging monetary policy. The further rates are below it, the more they boost the economy. And once they reach it, monetary stimulus has been fully withdrawn. On the face of it the lower forecast last week suggests the Fed is doing less to help the economy than it previously thought.
Roberto Perli, partner at research house Cornerstone Macro and a former Fed official, says the estimate is one of the influential factors underlying Fed rate decisions. He expects forecasts for the natural rate to drop even further, and thinks it will act like "gravity" to bring down bond yields again, assuming Donald Trump's tax cuts aren't passed.
However, there are three deep uncertainties about the Fed's natural rate forecasts that make them hard to translate into bond yield forecasts.
The first is the uncertainty about the natural rate itself. The "dot plot" of forecasts from each Fed policy maker range from 2.3% to 3.5% for the long run, a little lower than in June, while the median has dropped from 4.25% in 2012 to 2.8% last week. How sure can bond investors be that it won't go back up as fast as it's come down?
The range of forecasts emphasizes the uncertainty, but each forecast should also come with a wide range. Seth Carpenter, chief U.S. economist at UBS and another former Fed official, says estimates of the natural rate are "staggeringly imprecise," and Fed staff are constantly reminded of that. Yet, the estimates are essential to the Fed's calculations of whether monetary policy is supporting or slowing the economy.
Fed Chairwoman Janet Yellen emphasized the uncertainty about the natural rate again in a speech on Tuesday, when she said "its value at any point in time cannot be estimated or projected with much precision." In 2005 she suggested the natural rate estimate had a 2 percentage point error margin; if it held, a drop of 0.2 points in the median would be well within the bounds of pure chance.
Other economists put an even bigger error margin around their estimates. The widely used estimates created by Thomas Laubach at the Fed in Washington and San Francisco Fed President John Williams show that while the central estimate of the natural rate has come down a lot in the past few decades, the margin of error is bigger than the change.
The second reason investors might ignore the change is the uncertainty about what it means. Even if we were sure that the natural rate has fallen, would that mean higher or lower bond yields? On the face of it the question might seem dumb. If interest rates will peak at 2.8% instead of 3%, long-term Treasury yields -- which can be thought of as a series of short-term interest rates plus a risk premium -- ought also to be lower.
Yet, 10-year Treasury yields kept on rising, from 2.02% at their lows in early September to 2.33%. Mr. Perli puts this down to rising hopes of tax cuts. But as Valentijn van Nieuwenhuijzen, chief investment officer of NN Investment Partners in the Netherlands points out, it could also be that the Treasury risk premium is rising because investors are less sure of where rates will eventually settle. "The fact that [the Fed's r* estimates] are moving down is to some extent an acknowledgment that they're less certain," he said.
There is also a nasty short-term implication, says Francesco Garzarelli, co-head of macro strategy at Goldman Sachs. A lower natural rate is the result of assuming the economy has less potential to grow, which in turn might mean higher interest rates are needed to control inflation in the short run for any given rise in demand. How this interacts with a lower eventual rate is hard to predict.
The final uncertainty is about the people making the forecasts. Ms. Yellen's term ends next February, Vice Chairman Stanley Fischer is stepping down in two weeks, and three board seats are unfilled (with Randal Quarles nominated for one of them). Just a few of the dots need to rise to pull up the average forecast for the natural rate again.
After almost a decade of superlow interest rates it's hard to imagine the Fed Funds returning to the 5.25% reached in August 2007, from today's 1-1.25%. But we should put no faith in predictions that they'll stick at 2.8% in the long run, either.
Write to James Mackintosh at James.Mackintosh@wsj.com
(END) Dow Jones Newswires
September 28, 2017 15:20 ET (19:20 GMT)