Fuld Was Top CEO When Fed Last Raised as New Neutral Era Beckons

It may be hard to remember, but there was once a time when central banks raised interest rates.

The last time the Federal Reserve did so, in June 2006, Barack Obama was still a U.S. senator and Richard Fuld appeared on Barron’s list of the 30 most respected corporate titans.

And difficult as it is to imagine, central bankers will again make money more dear, maybe as soon as next year in the U.S. When they do, the pressing question will turn to how high they go.

As Bloomberg News suggested two months ago in a catchphrase since employed by Pacific Investment Management Co., rates won’t be as high as before the Great Recession. That’s because there’s a New Neutral.

The reference is to the neutral, or equilibrium, interest rate, one that neither spurs nor slows economic growth. In the 20 years ending 2007, the Fed’s benchmark rate averaged 4.8 percent. Interest-rate swaps show the U.S. federal funds rate will be around 2.8 percent in five years. It’s now about zero.

In the last 24 hours alone, Federal Reserve Bank of New York President Bill Dudley and Bank of England Deputy Governor Charlie Bean both said equilibrium rates are likely to be lower over time.

Just where “newtrality” lies is key for investors. Bill Gross, chief investment officer at Pimco, reckons the Fed will likely top out around 2 percent because the economic expansion now under way will prove relatively sluggish. That rate implies bonds will return 3 percent and stocks 5 percent in the next three to five years -- a “rather weak brew” for Gross’s taste.

‘Shallower’ Path

Fed officials are more aggressive in projecting their key rate will climb to about 4 percent beyond 2016. Chair Janet Yellen talks of a “shallower glide path” of rate hikes than traditionally.

At JPMorgan Chase & Co., chief economist Bruce Kasman says investors are questioning the likelihood of reaching 4 percent. His proxy: the economy’s 10-year trend rate of growth plus inflation, which recently fell below that level.

To Deutsche Bank AG economist Torsten Slok, the rate could go as high as 6 percent if the Fed hoards the $4.3 trillion of securities it holds on its balance sheet rather than mopping up the cash those purchases injected into the economy.

The search for the new neutral will be soon upon us and investors are wise to tune in.

Before it's here, it's on the Bloomberg Terminal.