Financial markets have focused recently on when developed-market central banks will likely raise interest rates. Just as important is the terminal rate, or how high central banks will ultimately raise rates.
Vanguard believes that markets are underestimating the U.S. Federal Reserve’s terminal rate. To understand why, it’s useful to understand the terminal rate’s relationship with the neutral rate, a long-term equilibrium that roughly depicts monetary policy that is neither accommodative nor restrictive.
“Short-term changes in the economy—headwinds or tailwinds—will push interest rates above or below neutral,” said Alexis Gray, a Vanguard senior economist in Australia who studies the neutral rate. “If the economy experiences tailwinds, interest rates might rise above neutral.”
Our 2022 economic and market outlook discusses the challenges that policymakers face in removing accommodative measures that were essential to economies’ surviving the COVID-19 pandemic but that, left unchecked, could produce too-strong tailwinds.
Market expectations for a terminal rate around 1.5% are more than a percentage point higher than the Fed’s current federal funds rate target of 0% to 0.25%. But they’re below the Fed’s 2.5% neutral-rate estimate and Vanguard’s 2% to 3% neutral-rate estimate.
We emphasize that the neutral rate has fallen for several decades, in part a function of global savings and investment relationships. We don’t anticipate a return to interest rates higher than those that prevailed before the 2008 global financial crisis, and the journey to the terminal rate could take several years.
“But the risk exists that run-ups in inflation and tight labor markets could cause the Fed to raise rates not only sooner than anticipated, but somewhat more sharply, which could spook the markets,” said Andrew Patterson, Vanguard’s U.S.-based senior international economist. “This highlights the importance for investors to remain disciplined and focused on their long-term goals.”