New Neutral Looms for Yellen-Carney When Stimulus Removed

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Janet Yellen, chair of the U.S. Federal Reserve. Close

Janet Yellen, chair of the U.S. Federal Reserve.

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Photographer: Andrew Harrer/Bloomberg

Janet Yellen, chair of the U.S. Federal Reserve.

Call it the “new neutral.”

When Federal Reserve Chair Janet Yellen and Bank of England Governor Mark Carney begin lifting interest rates from record lows, investors are betting the benchmarks stay below historic averages.

While neither central bank has plans for increases any time soon, improving economies are spurring debate about the appropriate levels for neutral interest rates, which neither stimulate nor slow growth. Interest-rate swaps show the U.S. federal funds rate will crest at 3.1 percent in five years, below the average of 4.8 percent in the 20 years ending 2007, while the key BOE rate tops out at 2.8 percent, about half its long-run average of 5 percent.

“Most people agree that potential gross-domestic-product growth is lower than before the crisis and will continue to be lower for at least a few more years,” so central bank benchmark rates also will be lower, said Torsten Slok, chief international economist in New York for Deutsche Bank AG.

Policy makers across the globe adopted emergency measures to stave off financial turmoil following the collapse of Lehman Brothers Holdings Inc. in 2008 and subsequent recessions. At the Fed, these included cutting the rate on overnight loans among banks to near zero in December 2008. The BOE chopped its official bank rate to 0.5 percent in March 2009.

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Mark Carney, governor of the Bank of England. Close

Mark Carney, governor of the Bank of England.

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Photographer: Chris Ratcliffe/Bloomberg

Mark Carney, governor of the Bank of England.

Now U.S. and U.K. policy makers are trying to tamp down investor anticipation of higher borrowing costs, saying increases aren’t on the immediate agenda.

‘Reasonable’ Expectation

Yellen said March 5 the U.S. economy “continues to operate considerably short” of the Fed’s goals for inflation and employment. Two days later, Fed Bank of New York President William C. Dudley said market expectations that the central bank will raise its main rate “around the middle of 2015” are “very reasonable.”

The BOE also isn’t in any rush to remove emergency stimulus that’s entering a sixth year because the economy probably will be in “extraordinary times a few years down the road,” Carney told lawmakers in the U.K. Parliament on March 11. Weakness from Europe and the higher cost of credit also reinforce the case for limited rate increases. “We need to take all those factors into account so that we are setting policy that’s consistent with an economy operating at it potential.”

‘Very Surprising’

Supporting his position are BOE data on the spreads between the central-bank rate and market interest rates. The average premium on a two-year fixed-rate mortgage with a 75 percent loan-to-value ratio was 1.87 percentage points above the benchmark in February, up from 0.32 percentage point in July 2007. Company credit spreads were about 1.9 percentage points higher in the fourth quarter than in the third quarter of 2007.

Because of the widening, “it would be very surprising if rates were to go back to where they were pre-crisis,” said Mike Amey, a London-based money manager at Pacific Investment Management Co.

Such an environment may restrain the yield on government securities. Interest rates on 10-year U.S. Treasuries will rise to 3.4 percent by the end of this year from 2.68 percent at 5 p.m. London time, based on the median estimate of analysts in a Bloomberg survey. That’s below the 4.32 percent average for the five years ending 2008.

Ten-year U.K. gilt yields will be above 3.5 percent when the BOE stops raising its benchmark, according to 86 percent of 100 investors in a Royal Bank of Scotland Group survey. The yield was 2.68 percent today and averaged 4.78 percent in the decade ending December 2008.

Rate Forecast

Most respondents in the RBS poll, released this month, said the BOE benchmark will reach the neutral rate in 2017, with almost half predicting it will be between 2 percent and 2.99 percent.

For equity investors, weaker-than-traditional monetary policy may represent a buying opportunity, even when interest rates do begin to rise, said Peter Dixon, an economist at Commerzbank AG in London. U.S and some emerging-market stocks could be bolstered, while prices of assets such as commercial and industrial property will increase, he said.

Central banks are making “a big bet that there’s a lot of slack in the economy and that they can continue to run interest rates below their natural level,” said Sarah Hewin, head of research at Standard Chartered Bank in London. “If you get that wrong, you very quickly start to generate inflation, but central banks are always more concerned about the risk of deflation than the risk of inflation.”

Asset-Bubble Trigger

Low borrowing costs also may spark asset bubbles. The average for a two-year fixed-rate mortgage in the U.K. was 2.37 percent in February compared with 5.74 percent in February 2008, BOE data show. That helped push home prices up 5.5 percent in December from a year earlier to a record 250,000 pounds ($415,200), while London values surged 12.3 percent to an all-time high of 450,000 pounds, according to data from the Office for National Statistics.

As rates stay low, the BOE is relying on so-called macroprudential tools to fine-tune prices, including ending support for home loans under the Funding for Lending Scheme this year.

“One of the problems with the low interest-rate policy is that central banks are washing their hands of the consequences of any asset-price booms,” Commerzbank’s Dixon said. This could stoke up a bubble in the next couple of years that “might pop quite badly later on.”

Countering Concerns

Yellen countered such concerns in response to a question during testimony before the House Financial Services Committee.

The Fed is “highly focused on trying to identify those threats,” she said Feb. 11. “The stock market broadly has increased in value very substantially over the last year, and our ability to detect bubbles is not perfect, but looking at a range of traditional valuation measures doesn’t suggest that asset prices broadly speaking are in bubble territory.”

At the end of their Jan. 28-29 meeting, U.S. (SPX) policy makers left unchanged their statement that they probably will hold their benchmark rate near zero “well past the time” unemployment falls below 6.5 percent, “especially if projected inflation” remains under their longer-run goal of 2 percent. They have said they can use other tools to control price acceleration, such as the ability to pay interest on the cash financial institutions park at the central bank.

Less-Specific Guidance

The jobless rate was 6.7 percent in February, and the Fed’s preferred inflation gauge was at 1.2 percent in January. With unemployment forecast to go below 6.5 percent this year, Yellen may announce guidance that’s less specific as soon as this week’s meeting of the Federal Open Market Committee.

Carney made such a shift after the U.K. jobless rate fell to 7.1 percent in the three months through November -- just above the 7 percent his Monetary Policy Committee had identified as the level for a possible rate increase. In February, the BOE issued a revised plan that includes a range of indicators including measures of involuntary part-time employment and long-term joblessness, and a renewed emphasis on communications with households and businesses.

The European Central Bank also is giving guidance and forecasts its key interest rate will “remain at present or lower levels for an extended period of time,” President Mario Draghi said on March 6. Euro-area inflation unexpectedly slowed in February, with consumer prices rising an annual 0.7 percent, down from 0.8 percent in January, the European Union’s statistics office in Luxembourg said today.

Output ‘Destroyed’

“We still don’t know how much potential output was destroyed during the crisis,” said Joachim Fels, chief international economist at Morgan Stanley in London. “Potential output growth has come down.”

In the U.K., GDP was 1.4 percent smaller in the fourth quarter than at the peak in early 2008, supporting the BOE’s view that there’s enough spare capacity to keep rates low without fueling price acceleration.

When the central bank does begin raising its benchmark, “it will probably do so only gradually and to a level that is likely to remain materially below its pre-crisis average of 5 percent for some while,” BOE policy maker Charles Bean said in a speech last week at the North East Chamber of Commerce in Darlington, northern England.

“I have something like a 2 percent to 3 percent range in mind here,” he said. “Even if we start to withdraw some of the exceptional monetary stimulus in the not-too-distant future, you should not expect bank rate to shoot straight back up to pre-crisis levels.”

To contact the reporter on this story: Emma Charlton in London at echarlton1@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net Melinda Grenier, Andrew Atkinson

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