The hunt for Goldilocks: central banks search for neutral rates

Almost all central bankers in the US and Europe agree rates must rise to tackle soaring inflation. What is open for debate is where they should stop.

Monetary policymakers and markets are trying to assess where lies the “Goldilocks”, or neutral, level of rates – the optimal level where an economy is neither overheating or being held back. But, after almost 15 years of tepid inflation and ultra-low borrowing costs, no one is quite sure what “just right” looks like.

“Everybody is trying to understand where the neutral rate is and where the tightening cycle will end up,” said Camille de Courcel, head of strategy for G10 rates in Europe at BNP Paribas. “It will be the driving factor for rates markets in the coming months.”

The risk is that policymakers get it wrong and let inflation jump out of control by keeping rates too low, or trigger a brutal recession by increasing too much. US Federal Reserve chair Jay Powell has said he hopes for a “softish landing”, but warned last week that raising rates may cause “some pain”. Bank of England governor Andrew Bailey has talked of a “narrow path” to rein in inflation without sending growth into reverse. European Central Bank president Christine Lagarde said “the challenges we still face are many”.

The neutral rate, where price pressures cool and output is near capacity, cannot be measured, only estimated. It is also a moving target that changes over time – before 2008, it was thought to be about 5 per cent in advanced economies.

Fed officials think it is now between 2 per cent and 3 per cent, when inflation is at 2 per cent. They raised interest rates by 50 basis points to 1 per cent at their last vote, and are expected to increase borrowing costs by another 50 basis points at each of their next two votes, leaving them on track to hit the range later this year. Others believe the neutral rate is higher; Bill Nelson, former deputy director of the Fed board’s division of monetary affairs, who is now chief economist at the Bank Policy Institute, puts it at between 4.5 per cent and 6.5 per cent.

The BoE believes neutral is even lower in the UK. Their forecasts show inflation persistently overshooting the 2 per cent target if interest rates remain at their current 1 per cent level, but falling short of this goal if rates rise to 2.5 per cent. That suggests the Monetary Policy Committee believes the right level lies somewhere in between the two bounds.

Eurozone policymakers think it is lower still. France’s central bank governor François Villeroy de Galhau puts the rate at about 1 per cent to 2 per cent, comparing it with “the moment when, while driving your car, you lift your foot from the accelerator pedal as you approach the desired speed”.

Fears are mounting that neutral might not be enough. Behind closed doors, officials are becoming increasingly concerned that their economies are now running so hot that rates will need to slam on the brakes. Inflation, now at multi-decade highs on both sides of the Atlantic, could prove stickier than expected, forcing them to tip the economy into a deep contraction, just as Fed chair Paul Volcker did in the early 1980s when he raised the federal funds rate to 20 per cent. Vicky Redwood, a former BoE official who is senior economic adviser at Capital Economics, said: “If high inflation has become more ingrained than we think, then a Volcker-shock style recession probably will be required.”

Krishna Guha, a former Fed staffer who is now vice-chair at Evercore ISI, said the question facing all central banks was “will you be forced to go beyond the neutral rate, even if you then have to come back down once inflation is tamed “.

Powell said on Tuesday the Fed “won’t hesitate at all” to raise rates above neutral if inflation stays high, adding that officials do not know with “any confidence” where neutral is. “They’ll try in phase one to get back to neutral and then they’ll evaluate,” said Jean Boivin, a former central banker in Canada now at BlackRock, forecasting that at that point “the world will be very different from where it is right now “.

Two charts showing that opinions differ on where the neutral rate lies.  US Federal Reserve compared with Bank of England Central Exchange rates (%), 2000 to 2020.

With figures out on Wednesday set to show UK inflation soaring to fresh highs in the year to April, the BoE – which has already raised rates three times this year – is under massive pressure to step up its response. Michael Saunders, one of the MPC hawks, said the central bank would need to move “relatively quickly towards a more neutral stance”, although he gave little hint about whether they would need to increase rates beyond that.

Lagarde has made clear that the ECB, which has yet to raise its deposit rate from minus 0.5 per cent but is expected to do so for the first time in a decade in July, aims to “normalise” rather than “tighten” monetary policy, moving towards the neutral rate but not beyond it.

The ECB president last week signalled that the ECB was in less of a rush than the Fed to reach neutral, saying: “The normalization process will be gradual”. But Dutch central bank head Klaas Knot on Tuesday became the first top ECB official to raise the prospect of a half-point rate increase in July, rather than the quarter-point rise that is widely expected.

Along with being more exposed to the conflict in Ukraine, the ECB is also hampered by the risk of borrowing costs shooting up in heavily indebted southern European countries like Italy.

The spread between Italy’s 10-year borrowing costs and those of Germany has already become the widest since the pandemic caused turmoil in debt markets in 2020.

While some ECB officials have talked about launching a “new instrument” to counter this risk, without a firmer commitment Guha said “spreads could blow out and force the ECB to take a timeout on rate rises”.

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