The New Neutral: Lower for Longer

After years at the zero bound, U.S. policy rates started heading higher in December 2015. PIMCO believes this rate hike cycle is likely to be the most gradual, most telegraphed one in the history of the Federal Reserve. Here, we offer our latest thinking on what to expect as this next phase unfolds for the U.S. economy.


Focus on the Rate Hike Path

The headwinds that once held back the U.S. economy have diminished. Still, international uncertainties remain, complicating the Federal Reserve's ability to continue the process of interest rate normalization. Should the Fed raise interest rates, it will be important to focus on the path of the tightening cycle. This means looking at the pace at which the central bank will raise rates, how much it will raise them each time and where and when it will stop. These factors ultimately have implications for an investor's long-term investments.

Focus on the Rate Hike Path chart

Lower for Longer

Given the market environment, we expect any Fed rate hikes to be gradual and that tightening will stop at a far lower level than in previous cycles. Unlike in past cycles, the central bank feels little pressure to adjust rates quickly because it is not “behind the curve” on inflation. Moreover, recent Fed research suggests that the neutral rate - meaning a rate that is neither stimulative nor contractionary - has fallen significantly in recent years and now may be as low as 2% on a nominal basis. This is in line with PIMCO's New Neutral thesis, and implies that the destination for the Fed Funds rate may be significantly lower than it has been in the past. While some may worry about the Fed's impact on an economic expansion that has become somewhat long in the tooth, it's important to keep in mind that such a gentle and limited policy adjustment is a far cry from the aggressive rate hikes that have spelled the end of previous expansions.

Lower for Longer chart

Short Rates Will Move the Most Over the Cycle

In a pattern that is consistent with previous Fed tightening periods, the yield curve is likely to flatten over the full course of a rate hike cycle, with yields on shorter-maturity bonds rising more than those on longer ones. If rates rise, overall market volatility should also pick up without the wet blanket of low interest rates and quantitative easing to dampen it. Given the limited scope of the expected tightening, however, we would expect yields on bonds across the yield curve to rise less than in previous cycles.

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