Rising inflation expectations could lead the Fed to take a more cautious approach to rate cuts...

 The US inflation trajectory is expected to continue to moderate, potentially leading to the Federal Reserve (Fed) cutting interest rates in the future. This expectation is influenced by the natural real interest rate, which is the underlying rate of return required by lenders and borrowers, and the potential impact of Trump's tariffs. While tariffs could initially push prices up, the long-term effect on inflation and real GDP growth is uncertain. The current 2024 GDP base at constant prices will serve as the foundation for future economic growth, which is expected to be influenced by a combination of these factors.

Inflation Expectations and Interest Rate Cuts:

Moderating Inflation:

The Federal Reserve Bank of Cleveland reports that inflation expectations have been trending down. This suggests that the Fed may be more likely to cut interest rates as inflation cools.

Interest Rate Expectations:

Reuters reports that rising inflation expectations could lead the Fed to take a more cautious approach to rate cuts.

Natural Real Interest Rate:

The natural real interest rate is the underlying rate of return that lenders and borrowers expect in a hypothetical situation with no inflation. It's a benchmark for assessing the effectiveness of monetary policy.

Real GDP Growth:

Trump's Tariffs:

Trump's tariffs could have an impact on real GDP growth. Some sources suggest that tariffs could lead to increased costs for businesses, potentially slowing down growth.

Inflation on 2024 Base:

The 2024 base for GDP at constant prices will be the benchmark for future growth calculations. If inflation continues to moderate, real GDP growth could be relatively strong in the coming years.

Housing Market:

Deloitte forecasts that lower interest rates could boost the housing market, contributing to overall economic growth.

In summary: The US inflation trajectory, influenced by natural real interest rates and potential impacts from Trump's tariffs, will be a key factor in the Fed's decision on interest rate cuts. The 2024 GDP base will be used to assess future real GDP growth, which is expected to be influenced by the interplay of these factors.

The concept of the neutral interest rate, the rate that neither stimulates nor constrains economic growth, is a crucial guide for central banks. Historical evidence suggests that the neutral rate has been on a downward trend in many countries, but the extent of its binding depends on various factors. Estimates of the neutral rate range from 1.4% to 3% in some countries.

Elaboration:

What is the Neutral Rate?

The neutral rate is the real interest rate (adjusted for inflation) that maintains stable inflation and full employment in the economy. When the policy rate is below the neutral rate, monetary policy is considered expansionary, aiming to stimulate growth. Conversely, when the policy rate is above the neutral rate, it is contractionary, aimed at curbing inflation.

Historical Trends:

Many central banks and economists agree that the neutral rate has declined in several advanced economies over the past few decades. This decline has been attributed to factors such as demographic changes, weak productivity growth, and a global savings glut.

Binding Constraints:

Zero Lower Bound: Historically, monetary policy has been constrained by the zero lower bound (ZLB), meaning interest rates cannot go below zero. The decline in the neutral rate has increased the frequency with which the ZLB is reached, limiting the ability to stimulate the economy during downturns.

Uncertainty in Estimation: The neutral rate is not directly observable, and estimating it accurately can be challenging. This uncertainty makes it difficult to determine the exact extent to which policy rates are binding.

Geographic Differences: The neutral rate can vary across countries due to differences in inflation expectations, growth rates, and other factors.

Recent Developments:

Recent studies have suggested that the neutral rate may have risen in some countries, potentially due to factors like rising inflation expectations. However, there is still a debate about the true extent of this rise and its implications for monetary policy.

Implications for Monetary Policy:

Understanding the neutral rate is crucial for central banks to set appropriate policy rates. When the neutral rate changes, it can affect the effectiveness of monetary policy. If the neutral rate is lower than previously thought, it may be harder to stimulate the economy with traditional monetary policy tools, potentially leading to a reliance on unconventional measures.

Examples:

The Riksbank's analysis, for example, suggests a long-term neutral interest rate between 1.5% and 3%, while the RBI has estimated a neutral rate between 1.4% and 1.9% for India.

Estimates for the neutral real interest rate in the US vary, but recent data suggests it's around 0.8% according to MacroMicro's HLW estimates, with a range between 0.6% and 1.4%. Some economists like Kathryn Holston, Thomas Laubach, and John Williams estimate it at roughly 0.6%. The neutral real interest rate is the rate at which monetary policy would neither stimulate nor restrain economic growth, according to the Brookings Institution.

Factors Influencing Neutral Rate Estimates:

Models and Assumptions:

Economists use various models, including those developed by Holston, Laubach, and Williams (HLW), to estimate the neutral rate. These models can have different assumptions, leading to varying estimates.

Survey-Based Estimates:

Surveys of economists can also provide insights into the neutral rate, potentially offering a different perspective than model-based estimates.

Long-Term Bond Yields:

Some measures of the neutral rate are derived from long-term bond yields, which may include risk premia and term premiums.

Recent Trends and Estimates:

Declining Neutral Rate: Studies suggest a decline in the neutral real interest rate over time.

Current Estimates: Recent estimates, particularly from the HLW model, suggest the neutral real interest rate is around 0.8%.

Real Federal Funds Rate: The real federal funds rate, which is the federal funds rate adjusted for inflation, has been higher than the neutral rate in some recent periods, according to MacroMicro.