Which central banks will head for neutral?

If the market knew where policymakers put the neutral rate (the rate that neither over-stimulates or under-stimulates the economy) it might act as some sort of anchor for the money markets as traders and investors try to judge just how much policy will be adjusted. But, of the major central banks, it is only the Fed that’s prepared to put pen to paper and write down an estimate of the neutral rate.

Admittedly, this estimate of the neutral rate comes from the median view of the FOMC’s nineteen members, and we don’t know whether these estimates come from rigorous economic analysis or mere guesswork. What’s more, the range of estimates is very wide. At the last forecasting round in September, the range of estimates for the longer-term, or neutral rate, went from 2.4% to 3.8%. The median estimate comes in at 2.9% which is a tenth higher than the prior estimate and above the 2.5% estimate that had formed the Fed’s median estimate from the middle of 2019 to the start of this year (barring one slide to 2.4% in March 2022).

Given the very wide range of estimates and the lack of clarity around the estimation process by FOMC members, we might question whether this neutral rate is worth very much. But it is still more than we get from other central banks like the ECB, the BoE and the BoJ. As such, it does present some sort of anchor for market pricing, and, perhaps coincidentally, current market pricing of the future Fed funds rate is bang-on the Fed’s neutral rate.

In short, the market is basically priced for the Fed to take the fed funds rate down to the ‘neutral’ 2.9% level by the late summer of next year and, thereafter, hold at this level for as far as the eye can see. It suggests that no matter the pace and extent of rate cuts in coming months, longer-term pricing of the Fed funds rate should be anchored close to this neutral rate - as long as the economy is developing as the Fed anticipates.

What about those central banks where policymakers suggest that rates will return to neutral, but seem unclear as to where the neutral rate actually lies? The likes of both Lagarde from the ECB and Bailey from the BoE both suggest that they won’t know where neutral is until after they have reached it, and hence are reticent to give any sort of guidance on where they think it might be. BoJ Governor Ueda seems equally reticent. Does this mean that money markets in the euro zone, the UK and Japan lack the same sort of anchor that we see in the US? If they do, it could mean that terminal rate expectations prove more volatile in these countries than we see in the US, and this could have a bearing on financial market prices.

To take an example, if we look at the pricing of policy rates in Japan, we see that there’s a steady increase from the current 0.25% rate to just under 0.7% over the next three years. This is interesting for, if we assume that it takes no longer than this for the BoJ to reach neutral, the implied rate is much lower than the 1% neutral rate that was suggested by one BoJ member, Tamura earlier this month.

According to the Standard Bank, now clearly it can’t say for sure that this is a common view within the BoJ or that the bank will get to such a neutral rate over the next few years. But what it does suggest is the possibility of a notable gap between market pricing and policymaker expectations and that’s something that could introduce significant volatility, as indeed we saw after the BoJ hiked rates in late August. For not only will near-term rate expectations prove volatile as rates are changed, but we may see more volatility in this assessment of the terminal rate as well.

In the Standard Bank’s view, this could give the yen an upward bias against the US dollar although, for other central banks that are easing policy, like the ECB and BoE, the risks may lie in terms of weaker currencies against the dollar should rate cuts lower terminal-rate expectations as well.