Powell and the Neutral Rate

The Fed chairman's language has eased pressure on equities, but the outlook is still uncertain
December 8, 2018 Updated: December 11, 2018

After hitting new lows for the year, equities bounced near the end of the month, rallying five days in a row after U.S. Federal Reserve Chairman Jerome Powell blinked on Nov. 28.

In his speech that day at the Economic Club of New York, Powell said the current interest rate level is “just below” neutral. In other words, it’s neither speeding up nor slowing down economic growth. Powell has been under a lot of pressure lately, as Wall Street has been worried the Fed is raising interest rates too quickly.

However, his comments allowed Wall Street to breathe a sigh of relief. The S&P 500 rallied 4 percent in the aftermath. The clear implication is that there will be one more rate increase in December, and then, the Fed will move to a strict data-dependent path, based primarily on inflation.

Remember, it was only in early October that Powell said rates were a “long way” from neutral. That comment sent stocks into a brief 10-percent correction.

I wonder what he’ll say at the December FOMC meeting about the neutral rate of interest, especially because equities have lost all their gains since the speech because of renewed trade friction between the United States and China.

In reality, the concept of the “neutral rate of interest” is a sham. It has no objective meaning, and can be anything the Fed wishes—which is the goal. See the definition from the Financial Times below:

“The neutral (or natural) rate of interest is the rate at which real GDP is growing at its trend rate, and inflation is stable. It is attributed to Swedish economist Knut Wicksell, and forms an important part of the Austrian theory of the business cycle.”

The Financial Times also explains:

“The neutral rate provides an important benchmark for policymakers to compare with the market rate. When interest rates are neutral, the economy is on a sustainable path, and it is deviations from neutrality that cause booms and busts. For example, if the market rate is pushed artificially below the neutral rate (for example through monetary expansion), then people receive a false signal to invest in more interest-sensitive projects. It is by separating interest rates from their `market clearing’ level that central banks have the potential to create monetary instability.”

Because the neutral rate is hypothetical, there’s no way to gauge it properly. Some economists think it’s currently 5 percent, while Morgan Stanley says it’s under 3 percent. Note that there is no clarity on for how long of a period GDP must grow at its trend rate, nor what measure to use for inflation. The entire concept is just a way to justify actions before and after the fact.

In essence, the whole concept of a “neutral rate” is unnecessary because the Fed strives to emulate what the interest rate would be if there was a completely free market in capital. If there was no Fed manipulation of rates, the interest rate would by definition always be at the neutral rate.

Trade Rattle

As the markets anticipated, President Donald Trump and Chinese leader Xi Jinping reached an agreement on trade just after the end of November, which amounts to a temporary stand-down in the two countries’ trade war. Trump agreed to hold off on raising tariffs imposed on Chinese imports, and China agreed to purchase a “very substantial” amount of U.S. products to reduce the trade deficit.

With those concessions made, the two sides will allow 90 days for broader negotiations over Chinese trade practices before the U.S. resumes ramping up retaliatory measures. The immediate effect of the deal will be a temporary reprieve for China on tariffs on $200 billion worth of goods, which were set to rise to 25 percent by Jan. 1, 2019, but will stay at 10 percent for the time being.

That’s a big change. China also agreed to toughen penalties on sales of fentanyl into the United States, which has become a major problem with drug overdoses and death. China will also consider approving the merger of Qualcomm and NXP Semiconductors.

In theory, this is all good news for the equity and commodity markets. But after the arrest of Huawei CFO Meng Wanzhou in Canada on the behest of the United States, the market stopped buying the G-20 détente and sold off heavily during the first week of December.

With this uncertain fundamental backdrop, most technical indicators on equities suggest we have moved into a bear market, but the Dow theory hasn’t confirmed this. The change in Powell’s tone and the temporary stand-down in a U.S.–China trade war at least provide a possibility of relief, but it wasn’t until global central banks moved into wholesale easing mode that the 2016 market jitters stopped.

The loss of the House of Representatives to the Democratic Party is a huge part of the fundamental picture. I believe this remains a very bearish factor, as any new fiscal policy that is needed to help the U.S. economy has almost no chance of passing, even if it benefits both parties. The Trump tax cuts and deregulation campaign, as well as capital repatriation, were the biggest drivers behind 2017’s blistering rally.

I currently lean to the bear side. I believe that after a stock-market rally in December, the war between Trump and the left will heat up in January and the economy will slow materially in 2019 without any new stimulus, as the 2020 election cycle has already begun.

Victor Sperandeo is a member of the Trader Magazine Trader Hall of Fame and the author of “Trader Vic: Methods of a Wall Street Master.”

 

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

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