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Good morning. I expect clever companies with bad news to announce secretly issue press releases at 2:35pm on Fed meeting days because they know all the financial journalists are watching the Jay Powell show. Let us know if we missed anything interesting yesterday: [email protected] and [email protected].

50 basis points, followed by nothing

Headlines were shown, pundits with smeared makeup appeared on cable TV, side bets were made galore, columns filled to the moon, analyst notes piled up in rickety stacks, social media lit up like a video game. And in the end, the market was incredibly unfazed. We got our big 50 basis point cut and stocks, bonds and currencies all shrugged in disdain in what seemed like a deliberate attempt to humiliate the financial experts.

This indifference was not only funny. It was also a fitting end to the confusion over whether it would be 25 or 50. Once the Fed had firmly signaled its shift to rate cuts, the goal was no longer the speed that mattered. A quarter of a percentage point difference in a single short-term interest rate, viewed in isolation, is of little consequence for the economy as a whole. What matters about the size of a particular cut at a particular time is what it says about the central bank’s future path: where it thinks rates should be and when it thinks it should get there.

This brings us to the neutral rate (or r*, if you like jargon): the unobservable level of interest rates consistent with full employment and low inflation. “We know it only by his works,” Chairman Powell likes to say, misquoting the Gospel of Matthew. He said it twice at his press conference yesterday. You’ve fallen below the neutral rate when inflation spikes; you’ve risen above it when risky assets contract and unemployment rises. In between, you’re in the dark, speculating about when you might fall off an edge or, alternatively, hit your head. Central bankers generally can’t stand still either. Economies have momentum and policy works with a lag. The Fed has to make a guess and move toward it.

The Fed’s current estimate for the neutral interest rate is 2.9 percent, according to its summary of economic forecasts, a tenth of a percentage point higher than the last SEP in June. That may not sound like a big change, but if you look at a slightly longer period, the Fed has changed its assessment significantly:

This shift is consistent with an emerging economic consensus that fiscal and monetary largesse, an aging population, deglobalization, higher productivity, and various other factors are driving the neutral rate higher. The practical significance of the change is that the Fed does not have too far to go to reach its (currently) considered target. If it moves at a brisk 50 basis points per meeting, it will be close to reaching its target by March of next year (of course, the intention is to proceed at a much more dovish pace if circumstances permit).

If the neutral rate is closer now, why cut 50 basis points? The Fed’s answer yesterday: because we can. The theme of the press release and press conference was that the excellent inflation trends allowed for a large but preemptive cut. We think the labor market is fine, and with inflation pretty much under control, we can take action to ensure it stays that way. Unhedged, for its part, believes the Fed is right about that. It is likely that inflation Is anything but whipped, and that the economy Is everything is fine, so a 50 basis point cut in itself carries little risk. But we don’t know – and probably nobody knows – where the neutral rate is. All we know is that we are now 50 basis points closer and getting closer.

For most investors, this is important primarily because the Fed could make a mistake. If the Fed goes too far, inflation rises again, and it becomes clear that the Fed will have to raise rates again, one will (to oversimplify) want to own stocks rather than Treasuries. If the Fed doesn’t go far enough and falling employment leads to a recession, the opposite bet is correct. Active investors have no choice at this point in the cycle but to have their own opinion about where the neutral rate is, so they can decide what kind of mistake the Fed is more likely to make. This is much more important than the size of the next cut. But 25 vs. 50 is a nice, well-defined debate, while estimating the neutral rate is a college economics seminar where the syllabus is secret, the exam date unknown, and your grade determines your salary.

The stakes are particularly high right now because risky asset prices are so high. Stocks, especially large US stocks, are valued at high multiples of earnings, and credit spreads are as tight as they can get. That means prices are geared toward stability, and a central bank that has to quickly change course because it has gone above or below the neutral rate is the exact opposite of stability. You’re betting on r* whether you know it or not.

A good read

Spies on ice.

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