Weekly Buzz: ⭐ Gazing at the “r-star” – The neutral interest rate

With inflation cooling from its recent highs, all focus has been on when the US Federal Reserve (Fed) might cut its key interest rate. But, in the meantime, the central bank has been doing something subtle, and crucial, that some may have overlooked – raising its estimates for the long-term “neutral” interest rate.

What’s a “neutral” interest rate?

The long-term neutral rate is the amount of interest that keeps the economy roughly in balance – neither too hot nor too cold (barring any unexpected shocks). It also serves as a stand-in for the “r-star”, that ideal, theoretical rate that balances savings and investments without pushing inflation out of control. And it sets the stage for where interest rates are headed.

Over the past six months, Fed officials have nudged their expectations for this neutral rate higher. When we strip out the outliers in their forecasts, the midpoint estimate has climbed above 3% and the median has risen too.

The thing is, the r-star is the Loch Ness Monster of economics: it’s talked about a lot, but no one’s actually seen it.

It’s influenced by a cocktail of economic factors, and it’s always on the move. Despite its elusive nature, this rate is a north star for central bankers, guiding them on when they should tweak interest rates, and by how much. The best they can do is try to estimate it using complex models that take into account various factors like growth, inflation, and how much people are saving or investing.

Bloomberg crunched the numbers and found that the neutral interest rate for ten-year US Treasuries took a dive from 5% in 1980 to just under 2% over the past decade. The impact was significant: attractive mortgage rates sparked a boom in house prices and cheap financing allowed even unprofitable firms to expand.

But we may be at a turning point. Major drivers like AI are likely to push the neutral rate of interest higher at 4%. And it may stay there, well into this decade and the next.

As an investor, what does this mean for me?

The era of ultra-low interest rates may be over, with a pendulum swing on neutral rates potentially shaking things up. As an informed investor, keep the r-star in view – interest rates are a huge driver of almost all asset prices, so a long-term shift could have big implications.

One way to ensure your portfolio is equipped to handle a different long-term macroeconomic environment is to simply diversify. Diversification works particularly well for navigating various interest rate environments because different assets react differently to rate changes. For a head start, consider any one of our General Investing portfolios – they’re invested across asset classes and geographical regions.

This article was written in collaboration with Finimize.

📖 A Little Context: The Era of Easy Money

Welcome to a new section of Weekly Buzz, A Little Context, where we dive just that bit further into the oftentimes interesting (sometimes dramatic!) history behind the markets!

For over a decade, we've lived in a world of ultra-low interest rates – a period often dubbed the "Era of Easy Money". This chapter in economics began in the aftermath of the 2008 financial crisis, when central banks slashed rates to near-zero to stimulate economic recovery. The low-rate environment became the new normal, shaping everything from mortgage rates to stock valuations.

However, as inflation surged and economies recovered in the post-pandemic era, central banks are now reassessing their stance. The rise in the neutral rate signals a possible shift away from this era of extraordinarily accommodative monetary policy.