The US Fed’s uncertainty over a neutral rate is bad for bonds

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Subscribe to enjoy similar stories. The US Federal Reserve on Wednesday began its policy easing with a bang. Much of the focus was on its decision to cut interest rates by half a percentage point from a two-decade high.

But the key question for the US bond market is where rates will land once all is said and done. Nobody knows for sure, and Fed chair Jerome Powell injected enough uncertainty to ensure a choppy ride ahead. The Fed’s Summary of Economic Projections showed that the median respondent among Federal Reserve Board members and Federal Reserve Bank presidents now sees the “longer-run" federal funds rate landing at around 2.9%, up from about 2.8% in its previous quarterly update.

That’s the rate that policymakers think will prevail in a balanced economy with a strong labour market and low and stable inflation. For years, policymakers thought that ‘neutral’ was around 2.5% (or 0.5% in ‘real’ terms, adjusting for inflation held at 2%). Not only have their estimates drifted higher, but I suspect that they could climb a bit more to converge with the median private sector estimate of 3.1% in the Federal Reserve Bank of New York’s survey of primary dealers.

My Bloomberg Opinion colleague Bill Dudley, president of the New York Fed from 2009-2018, told me Wednesday that neutral is probably around 3% to 3.5%—and could be as high as 4%. The upshot is that longer-term bond yields don’t have much room to fall in the near-term, unless the economy weakens materially. These developments help explain why yields on the 10-year Treasury note actually rose by five basis points after the Fed’s decision.