The report highlights key factors driving an upward adjustment to the U.S. neutral interest rate (r*), now estimated at 3.0%-3.5%. Expansionary fiscal policies under the incoming Trump administration, including tax cuts and restrictive trade and immigration measures, are expected to fuel inflationary pressures and disrupt labor and trade flows. Rising productivity further increases potential output, reinforcing the need for a higher r*. Investor expectations and forward rates align with this recalibration, reflecting economic resilience and structural changes. The analysis suggests the Federal Open Market Committee (FOMC) should revise its current r* estimate to reflect these evolving dynamics.
New economic regime
The analysis critiques the Federal Reserve’s current r* estimate of 2.875%, arguing it underestimates the economic pressures expected from the incoming Trump administration’s fiscal expansion and trade policies. These policies, including tax cuts, targeted spending, and immigration restrictions, are anticipated to drive demand-driven inflation, exacerbate labor shortages, and disrupt supply chains, all contributing to a higher neutral interest rate.
Policy risks
The report highlights market signals such as the 10-year overnight indexed swap (OIS) rate of 3.4%, which reflects investor reassessment of r*. However, it cautions that this rate may include an elevated term premium, influenced by policy risks and inflation uncertainties, complicating its interpretation as a direct indicator of r*.
Additionally, the Federal Reserve’s reliance on models like the Holston-Laubach-Williams (HLW) framework may have overemphasized long-term productivity declines, biasing r* estimates downward. The report suggests the Fed must revise its r* outlook upward to better align with economic resilience and avoid the inflation risks posed by further rate cuts.
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