The Zhitong Finance App learned that Christopher Waller (Christopher Waller), a popular candidate for the next chairman of the Federal Reserve, said on Friday that in the future economic cycle, interest rates may be higher than the low interest rates in the 2010s, but this has not yet been determined.

In his speech at the Reykjavik Economic Conference in Iceland, Waller focused on the controversy over the so-called neutral interest rate (R-Star). The question sounds technical, but it has important implications for the Federal Reserve's long-term policy.

R-Star, usually written R*, is a theoretical concept in economics. Unfortunately, for economists and market participants, neutral interest rates are not as instantly measurable as bond yields or unemployment rates; they can only be observed to a certain extent after the fact.

R* refers to the actual interest rate after adjustment for inflation. Under this interest rate, the economy's demand for savings and investment is balanced. Neutral interest rates neither stimulate nor inhibit growth and inflation. In other words, this means that monetary policy is neither tight nor loose.

Waller said, “You can think of R* as the level of the actual federal funds rate after all cyclical fluctuations in the economy have been removed, including short-term policy tightening or easing sometimes required to restore employment and inflation to the Federal Open Market Committee (FOMC) goals.”

The economy should balance over time, and the actual federal funds rate should equal R*.

In the latest economic forecast for March, Federal Reserve officials set the median estimate of the long-term federal funds rate at 2.6%, 0.1 percentage points higher than the forecast three months ago. Subtracting the central bank's 2% inflation target, the neutral interest rate estimate is 0.6%.

The actual yield on 10-year US Treasury bonds can be used as a proxy for neutral interest rates because it represents the market's collective view of long-term interest rate trends. Waller pointed out that over the past 40 years, this indicator has continued to decline, indicating that R* is declining. The actual yield on current 10-year treasury bonds is around 2%.

Recently, many economists and commentators believe that the US economy's neutral interest rate may be higher today than before the COVID-19 pandemic. This shows that once the Federal Reserve starts cutting interest rates, it will not cut interest rates as much as in the past.

Theories about why the economy can balance at higher interest rates include: faster productivity growth; structurally high inflation due to the return of production to the US, the green transition, and an aging workforce; and a riskier, more uncertain world due to geopolitical instability and frequent natural disasters, which may drive up bond yields.

Waller wasn't sure about that. He pointed out that the long-term decline in real yields on 10-year treasury bonds is largely driven by forces that still exist.

He said, “As a decision maker, it is important to understand what drives any change in R in order to use it to guide my policy deliberations. I cannot simply assert R's rise based on intuition. There must be a reasonable economic explanation for the reasons for its rise or fall.”

Waller pointed out that the liberalization and globalization of capital markets has made foreign buyers one of the largest holders of US Treasury bonds; an aging population that values risk-free income assets; and stricter financial regulations that push banks to hold more treasury bonds. These factors have caused demand to exceed supply over the past 40 years, driving down 10-year Treasury yields and R*.

He believes these demand-side dynamics will not be reversed, but he points out that the US government's massive borrowing to fund a continuing budget deficit is unsustainable. “If the supply of US Treasury bonds starts growing faster than demand, this will mean falling prices and rising yields, putting upward pressure on R*.”

Waller has been a member of the Federal Reserve since December 2020 and is a voting member of the Federal Open Market Committee (FOMC).

At the April 30-May 1 meeting, the FOMC voted unanimously to keep the federal funds rate within the target range of 5.25% to 5.50%, the highest level in two decades and has been the case since July. Policymakers also announced that they will reduce the pace of the Federal Reserve's quantitative austerity program.

Interest rate futures pricing on Friday showed that the federal funds rate target is less than 1% likely to change at the next FOMC meeting from June 11 to 12. The market believes that the probability of interest rate cuts in September is about 50%.