One year ago, the “smart money” in financial markets thought the Federal Reserve, after ending quantitative easing (QE), would in 2015 commence a rate hike cycle that ultimately would lead to an “old normal” policy rate of around 4%. Since then, expectations for the longer run Fed policy rate priced into interest rate futures have collapsed to below 3% (Figure 1). This has occurred in tandem with strong GDP growth, robust gains in payroll employment and then the end of QE. Why?
We believe this is due, in no small part, to the growing recognition that, for at least the next three to five years, the world’s major central banks, including the Fed, will be operating in a New Neutral world, a world in which average policy rates are set well below the levels that prevailed before the crisis.
So how did we get here, and what does it mean for investors?
Over the past 15 years, the global economy has operated under two different growth models. Between 1999 and 2007, the growth model operated through ever larger trade imbalances between emerging market (EM) and commodity-exporting countries – which ran larger and larger surpluses – and a group of rich countries – first and foremost the U.S. – which ran larger and larger trade deficits.
Global imbalances were then seen as a problem by some, but they were really a symptom of the global distribution of aggregate supply and demand, with excess supply in the high-saving EM countries and excess demand in some low-saving rich countries (and with energy-exporting countries doing quite well as they exported to both). These supply-demand and saving-investment imbalances generated huge international capital flows that were sufficient to bring global demand in line with the abundant global supply of goods at something approximating the full employment of global resources.
That growth model obviously broke down in the global financial crisis years of 2007–2009 as global imbalances shrank in line with global aggregate demand. From 2009–2014, the global economy has operated under stimulus from “unconventional” monetary policies that pushed policy rates to zero and ballooned central bank balance sheets through massive chunks of quantitative easing. Also, global policymakers “went Keynesian” for at least a couple of years during and following the crisis by delivering a large dose of fiscal stimulus.
The good news is that, as a result, the global economy avoided a depression and − so far − deflation. But that’s all policymakers did or could reasonably do. The reality is that six years after the darkest days of the global financial crisis, average growth in the global economy is modest and the level of global GDP remains below potential. The global economy has not, as of today, found a growth model that can generate and distribute global aggregate demand sufficient to absorb the bountiful aggregate supply of goods and commodities. Unless and until it does, we will be operating in a multi-speed world, with countries settling in to historically modest trend rates of potential growth.
Modest potential growth, in and of itself, would be disappointing but not a disaster in an unlevered global economy. But of course that is not the world of 2014. As shown in Figure 2, the total stock of public and private debt outstanding in the global economy is at an all-time high in dollar terms (and as a share of global GDP is larger today than it was in 2007). So while an excess of private sector and – especially in Europe − sovereign leverage contributed to the global financial crisis, there has been no decline globally in aggregate leverage. Private sector deleveraging has, at least on a global basis, been replaced by public sector leverage. And of course China faces its own challenges as it aims to rein in the explosive growth of its own home-grown and very levered shadow banking system.
As a direct consequence of this global leverage overhang and the modest rates of potential trend growth to which the major economies are converging, we believe that the world’s major central banks have entered a new era, The New Neutral for global monetary policy rates. In this world, neutral policy rates will be well below the policy rates that prevailed before the financial crisis, which in the U.S. averaged about 2% over inflation. Because the neutral policy rate, like the level of unemployment consistent with full employment (the non-accelerating inflation rate of unemployment, or NAIRU), is not directly observable, estimates of it are subject to uncertainty. That said, it is our belief that over most − and perhaps all − of our three- to five-year secular horizon, the neutral policy rate for the U.S. will likely be closer to 0% in real terms than to the 2% real neutral policy rate that prevailed before the crisis.
The New Neutral is a natural evolution from the New Normal. The term New Normal described a two-speed world recovering from the global financial crisis in 2008 and confronting the sovereign debt crisis in Europe from 2010–2012. It featured initially rapid EM growth and sluggish developed market (DM) growth, which pinned policy rates at close to zero in DM countries. The New Normal has evolved; instead of a two-speed world, with emerging economies growing robustly and developed economies growing modestly, we now see a multi-speed world of economies converging to respective trend growth rates below, and in some cases well below, those recorded in the “old normal.” As convergence to trend occurs, it will feature monetary policy normalization in some countries, but at a slow pace and to average policy rates well below those that prevailed before the crisis.
The neutral policy rate defined
The concept of a neutral policy rate has a very specific meaning in contemporary central bank practice. The neutral policy rate is the short-term interest rate consistent with
- full employment,
- inflation equal to the central bank’s inflation target and
- inflation expectations that are “well-anchored” to the inflation target.
The neutral policy rate is related to the neutral real policy rate: Neutral policy rate = neutral real policy rate + inflation target.
Importantly, as with the NAIRU, the neutral real policy rate is not directly observed and economic theory also predicts it can be time-varying and can depend on global as well as domestic macroeconomic factors. Federal Reserve officials themselves have cited a number of reasons why the neutral real policy rate several years in the future may be below the appropriate neutral policy rate that prevailed before the crisis, including
- slower growth in potential output,
- higher precautionary savings,
- higher global savings and
- slow credit growth.
Figure 3 provides empirical estimates of the neutral real policy rate as published and updated by Federal Reserve Bank of San Francisco President John Williams and by Board of Governors economist Thomas Laubach. Their estimates have declined sharply over the past dozen years, and, in recent years, are negative. A negative real neutral policy rate means that even with the nominal policy rate at zero, the economy is still operating with inflation below target and with unemployment above NAIRU.
The real neutral policy rate is closely related to the concept of the “secular real policy rate” introduced by PIMCO’s Saumil Parikh (“Forecasting Bond Returns in the New Normal”). The secular real policy rate is estimated as the 10-year moving average of the realized real policy rate. As shown in Figure 4, over the 100 years between 1910 and 2010, the secular real policy rate in the U.S. averaged 0.39%. Recent IMF estimates of the average neutral real policy rate for the global economy remain negative until 2017, before rising gradually to 1% by the end of the decade.
The neutral policy rate: an anchor, not a ceiling or floor
The neutral policy rate is important for assessing valuation of different asset classes over a secular horizon because we expect it will anchor the expected average policy rate over the secular horizon − but not because we expect the neutral policy rate will serve as either a ceiling or floor for the actual policy rate. There are many reasons why a central bank could set the actual policy rate above the neutral policy rate for long periods of time, including
- unemployment falling below the NAIRU,
- inflation rising above the target,
- inflation expectations rising above the inflation target and
- a hawkish mistake by the central bank.
Figure 5 plots the federal funds rate between the 1992 introduction of the Taylor rule – with its assumption of a constant real neutral policy rate of 2% and a constant nominal policy rate of 4% – and 2008 when monetary policy in the depth of the financial crisis first hit the zero lower bound. As the chart shows, during these 17 years, the average nominal policy rate was equal to the Taylor rule assumption of a neutral 4% nominal policy rate.
What accounted for the Fed’s deviations from neutral during these years? As Figure 6 shows, deviations from the Taylor-rule neutral during these pre-crisis years are quite well explained by the unemployment rate (plotted on an inverted scale). When unemployment was low, the policy rate set by the Fed was above the Taylor-rule neutral, and when it was high, the policy rate was set below the Taylor-rule neutral.
From the most recent Summary of Economic Projections (SEP), we know that the central tendency projection of the FOMC is for the unemployment rate in 2017 to be pushed below the central tendency projection for NAIRU of 5.3%, which both the FOMC and the Bloomberg consensus project will be reached in 2016. If indeed the economy runs “hot” in future years, and if the Fed reaction function under Chair Janet Yellen is similar to the Greenspan-Bernanke reaction depicted in Figure 6, we would expect the federal funds rate in the future to be eventually pushed above the new neutral policy rate.
Symmetrically, if the economy surprises on the downside, the fed funds rate may not in the next several years get to new neutral. Thus, because the neutral policy rate is neither a ceiling nor a floor for actual policy rates, and because persistent deviations from neutral will be driven by the business cycle, investing in The New Neutral world will require getting the business cycle right as well as getting the neutral policy rate right.
PIMCO’s three Cyclical Forums each year will provide opportunities for us to update our cyclical views on the global macro business cycle outlook, which in turn inform our views about cyclical deviations of monetary policy rates from neutral. In addition, our annual Secular Forum will provide the opportunity to assess and refine our views about neutral and secular real policy rates over the upcoming three to five years.
What the Fed is saying and what is priced in
Since Janet Yellen’s first meeting as Fed chair in March 2014, each Fed statement has said, “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
The FOMC currently projects, according to the central tendency of the individual participants’ forecasts, that the economy will be operating at “mandate-consistent levels” of unemployment and inflation by the end of 2016, at which time, the median projection indicates, the appropriate federal funds rate will be 2.85%, well below the old neutral Taylor-rule estimate of a 4% neutral nominal policy rate. The Fed statement and central tendency projections are consistent with The New Neutral view.
Figure 7 provides five different estimates of the neutral Fed policy rate at year-end 2016. All five estimates are well below the old neutral assumption of a 4% nominal neutral policy rate. Moreover, all five estimates imply a neutral real policy rate in 2016 closer to zero in real terms than to the Taylor-rule assumption of a 2% real neutral policy rate.
Eurodollar futures and overnight index swaps express the market’s expectations for the overnight return on money in the future, and for year-end 2016 they are both currently quoted below 2%. The expectation for what the one-year real yield will be in three years plus the Fed’s 2% inflation target is currently quoted at just over 2%. And while the “median” of the blue dots from the survey of future expectations for the fed funds rate of individual FOMC members is closer to 3%, the so-called “fourth blue dot from the bottom,” which is widely presumed to represent the thinking of the key members of the committee, is closer to 2%, as are the expectations of primary dealer chief economists, according to the Fed’s survey.
Figure 8 provides five different estimates of the neutral Fed policy rate at the end of our secular horizon in 2018. Here we see evidence of a divergence between market pricing and the Fed “blue dots,” which indicate that in the longer run, the Fed projects the neutral policy rate rising to 3.75%. Only time will tell, but as of this writing, the market is betting against this.
In this New Neutral world, there are several secular themes for investors to consider.
References and related articles
Balls, Andrew. “Andrew Balls Discusses PIMCO’s European Secular Outlook,” June 2009.
Clarida, Richard. “The Mean of the New Normal Is an Observation Rarely Realized: Focus Also on the Tails,”
Clarida, Richard. “What Has – and Has Not – Been Learned About Monetary Policy in a Low Inflation Environment? A Review of the 2000s,” October 2010.
Clarida, Richard and Saumil Parikh. “Guidance Counselors,” November 2013.
El-Erian, Mohamed. “A New Normal,” May 2009.
El-Erian, Mohamed. “Mohamed El-Erian Discusses PIMCO’s Secular Outlook and Investment Strategy,” May 2009.
Gross, Bill. “On the ‘Course’ to a New Normal,” September 2009.
Gross, Bill. “Staying Rich in the New Normal,” June 2009.
Hodge, Douglas. “Restoring Trust in the New Normal,” October 2012.
McCulley, Paul. “The Uncomfortable Dance Between V’ers and U’ers,” November 2009.
Parikh, Saumil. “Forecasting Bond Returns in the New Normal,” March 2013.
Parikh, Saumil. “Forecasting Equity Returns in the New Normal,” November 2012.
Opportunities in global rates: The past will not be prologue. In a world of slowing potential growth and a new neutral anchor for global policy rates, there will be opportunities in hard duration, exposure directly to interest rates, when and if markets sell off based an old neutral models of central bank reaction functions.
Opportunities in global equities: The New Neutral will support valuations. Because asset valuation depends crucially on discounting expected future cash flows, a New Neutral for risk-free rates will impact all asset classes. In particular, it will support higher equity multiples. If bond yields imply that futures are about right, then so are current equity multiples, which may appear elevated to those not taking into account a new neutral rate for discounting cash flow.
Opportunities in global credit: Seek out secular winners, one company at a time. In a multi-speed world, there will be secular winners and laggards. Indeed, it is possible that no country will grow at the average rate! For those who invest in bottom-up research on securities, sectors, companies and countries, a multi-speed world will offer the opportunity for abundant rewards. Those who are content to hold a market, or benchmark, portfolio could be leaving money on the table.
Opportunities in emerging markets: Forget the acronyms, do the homework. For too many years, too many investors have been content to load up on equally weighted portfolios of BRICs (Brazil, Russia, India, China). If that ever made sense, in a multi-speed world it will do so no longer. Again, bottom-up research on companies and countries brings potential rewards.
Opportunities in currencies: The U.S. dollar. Our baseline case sees the U.S. economy achieving full employment with a New Neutral, but positive, nominal policy rate. Alas, we are less optimistic with regards to the economic prospects for the eurozone or Japan, and see the European Central Bank and the Bank of Japan all-in for quantitative easing and in no hurry to raise rates. In this scenario, investors should consider going long the dollar as well as the currencies of other economies likely to be secular winners.
Opportunities in asset allocation: Opposites attract. One of the few financial correlation relationships to survive the crisis is the negative correlation between equity risk and interest rate risk. Bond allocations have been and should continue to be natural and efficient diversifiers across a broad range of asset allocation strategies. Although diversification does not ensure against loss, investors who focus only on comparing a bond coupon to an equity dividend will likely miss out on one of the best investment opportunities and thus could also lose out on higher risk-adjusted returns.