Column-Fed’s Steer as Crucial for Markets Amid Policy Actions: McGeever By Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) – Former Federal Reserve Chair Ben Bernanke once humorously remarked that "monetary policy is 98% talk and only 2% action." While his figures may have been an exaggeration, the influence of policymakers’ communications on financial markets is undeniably significant—perhaps even more impactful than their actual decisions.

Financial markets are inherently forward-looking, a fundamental characteristic that shapes their dynamics. Given this, it is no surprise that guidance from Federal Reserve officials plays a crucial role in driving investor behavior and influencing asset prices.

As the Federal Reserve has recently initiated its rate-cutting cycle, discussions are heating up around the concepts of neutral, natural, and terminal interest rates, along with the timeline for reaching these benchmarks.

A key point of this conversation is "R-star," the estimated equilibrium interest rate that neither stimulates nor constrains the economy—a theoretical figure that is challenging to pinpoint in real time.

Much analysis has gone into estimating where the Fed believes R-star lies and its implications for financial conditions. However, the more pertinent question might be whether the precise location of R-star truly matters. The economy and capital markets often react positively not because R-star has been reached but because the Fed signals a move toward this elusive target, or, more commonly, because investors anticipate such a shift. This suggests that the discussions surrounding R-star may be more critical than its actual value.

SIGNALS AND NOISE

Following the recent half-percentage-point rate cut, the federal funds rate was positioned in the 5.25%-5.50% range—the highest level in 17 years when adjusted for annual inflation. Analysts from JP Morgan indicated that real interest rates, relative to estimates of R-star, were at their highest in three decades.

Chicago Fed President Austan Goolsbee recently emphasized that real policy conditions have tightened significantly over the past year due to decreased inflation, providing the Fed with ample opportunity to ease monetary policy. "Make no doubt about it— we’re hundreds of basis points above the neutral rate. If conditions continue like this, there are a lot of cuts to come over the next 12 months," Goolsbee remarked.

However, one could interpret Goolsbee’s point—that policy has tightened even without rate hikes—as suggesting that easing restrictiveness tends to be stimulative, and that is what, currently, markets are banking on.

Consider that the three major U.S. equity indexes have surged between 20% and 30% over the past year, high-yield bond spreads have narrowed by around 100 basis points, and most companies have had little difficulty refinancing their debt. These developments are not typical indicators of strictly restrictive financial conditions, implying that R-star may be higher than previously estimated.

Yet, it’s also important to recognize a more nuanced cycle: rising market sentiment may have muted the intended effects of elevated policy rates. In essence, markets quickly shifted and began integrating rate cuts into their expectations, resulting in conditions that were looser than what central bank theory might predict.

RISK ON?

Despite appearances, investors’ enthusiasm for risk may not be entirely unwarranted, as historical data demonstrates this trend as a rational reaction. Fed projections and market pricing suggest that the federal funds rate could be cut by roughly 200 basis points by 2026—a considerable adjustment.

The experiences of the past few decades indicate that significant rate cuts often coincide with recessions, typically leading policy into a stimulative phase. Historically, U.S. stocks have risen an average of 5% in the year following the Fed’s first cut, and as much as 18% when a recession is not on the horizon, according to analysts.

Currently, a recession is not the expected outcome by the U.S. central bank or financial markets. The substantial inflation-fighting rate hikes of the early 1980s triggered serious recessions, yet once the rates fell, they remained restrictive throughout the decade, during which U.S. stocks experienced a 230% rise.

Ultimately, does it matter how investors view R-star? Perhaps not directly, but it’s crucial for them to understand how Fed officials perceive it and how these views influence their decision-making, especially when juxtaposed with market-based financial conditions indices that might be signaling contrary trends.