What is the neutral real interest rate? What about Munis?

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We’ll open this commentary with five of the slides used during the USF-GIC’s April 27 virtual (and in-person) conference on the Russian-Ukrainian war and its impacts. The five-part series, “Ukraine: What’s Next?” is a collaboration between the University of South Florida and the Global Interdependence Center. National Chief Economist David Berson presented current economic themes and various impacts on inflation in recent years, culminating in the Ukraine crisis. These slides were part of Berson’s presentation folder. The set of slides is a terrific representation of the nature of the intersection of the aggregate supply shock and aggregate demand shock that we experienced and how that changed economic metrics.

Here are the five slides in order and the commentary attached to each.

growth and inflation had both stabilized at around 2% before covid
the initial impacts of covid were to reduce both demand and supply
modest supply chain recovery was overwhelmed by expansionary monetary and fiscal policy
this is where we are today - solid growth and high inflation
the Russian invasion of Ukraine (as well as China's new covid-induced lockdowns) created another negative supply shock

These slides are part of the full public conference presentations. We thank David Berson for permission to share them with our readers.

Let’s move on to takeout.

We have already explained how difficult it is for the Federal Reserve to determine interest rates when there is simultaneously an aggregate demand shock and an aggregate supply shock (“Two links and a rant: Zero-rated Munis, quantitative tightening and media trolls”,). You can see it on these slides. We have also written how the current circumstances are a “double whammy”, since the pairing of these two aggregate shocks has happened twice in two years and the recovery from the first pairing of shocks was not complete until until the second shock pairing occurs.

David Berson sent me this note:

“Did you know that in the 293 quarters since the first quarter of 1948, there are only five instances in which the U-3 [unemployment] was below 4.0% and real GDP was negative? Yes, the first quarter of 2022 was one of them.


1953 Q31953 Q41969 Q42020 Q1

Readers may note that the first quarter of 2020 was the first pandemic shock quarter. Also note that the shock of the fourth quarter of 1969 coincided with the Hong Kong influenza pandemic of 1968-1969. It also coincided with the Vietnam War. Readers may recall that the Hong Kong flu killed an estimated 4 million people worldwide.

Also note that 1953 Q3 and Q4 coincided with the Korean War; there was no pandemic raging at the time. The deadly Asian flu pandemic exploded later, in 1957-1958.

So what’s the takeaway here? Finding a neutral real interest rate in times of epidemic shock and war shock is almost impossible. The shocks are large and the aggregates are difficult to estimate.

There is another important distinction to consider when thinking about the neutral real interest rate. The issue was raised in a private conversation I had with a central banker, so I will preserve anonymity but raise the issue.

Is there a difference between a desired neutral real interest rate for financial market agents and a desired neutral real interest rate for the real economy and its agents? This question is a sophisticated way to research the differences between Main Street and Wall Street.

Those of us who work in financial markets tend to focus on the financial market-neutral real rate of interest. Policy makers focus on the real economy. We tend to assume that Main Street and Wall Street view the neutral rate as the same or similar number.

But are we right? I’m not so sure. In a double whammy scenario, it’s almost impossible for Main Street and Wall Street to line up, especially when it comes to the neutral real interest rate.

Allow me to conclude.

We discussed the difficulty for central banks to make policy decisions in the event of a double shock. We have argued that the cacophonous criticisms that troll central banks add nothing useful to these conversations. We argue that research on these issues is complex and requires skill. There is a concentration of these skills in the intellectual power residing at the Federal Reserve and other central banks.

We have also argued that it is acceptable to say “I don’t know”. There is nothing wrong with that. It is the “know-it-all” attitude that is most disturbing.

We thank David Berson for the set of slides which makes the issue of the intersection of aggregate demand shocks and aggregate supply shocks more easily understandable for our readers.

Here is our own best guess. And remember, this is an ESTIMATE. The flat US Treasury term structure at around 3% from 2 to 30 years indicates that the medium-term nominal neutral rate is closer to the 3% level than the 6% level that others have defined as the upper extreme. The next question is how much of the nominal rate represents inflation (and inflation expectations) and how much is real? History tells us that the longer-term neutral real rate is close to zero for risk-free US sovereign debt. This would imply that the inflation component is around 3%.

We therefore conclude that the market-based pricing mechanism favors the 3% lower natural rate as a nominal outcome once these double-effect shocks have run their course and stabilized at a significant equilibrium.

We will find out. If we get any closer, the high-quality, tax-free 4% municipal bond is currently very, very cheap. We position selected bonds for our clients in separately managed accounts.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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