CONTRIBUTORS
Wylie Tollette, CFA
Chief Investment Officer,
Franklin Templeton Investment Solutions
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Executive summary
As of March 2024, developed market central banks have raised rates to levels not seen in decades, but so far, many economies have been resilient. Inflation, which fell broadly throughout 2023, is proving to be sticky in some areas. Growth has been most resilient in the United States, despite the US Federal Reserve (Fed) raising rates more aggressively than many developed market peers. While it is commonly accepted that monetary policy operates with a lag, the exact timing and magnitude of that lag remain heavily debated. Fed Chair Jerome Powell has signaled that rate cuts could be on the table in 2024; this anticipated “Fed pivot” has contributed to an easing of financial conditions relative to their peak. This raises the all-important question, “Have central banks raised too much, too little, or just enough?” To answer this question, we explore the concept of the natural rate of interest, otherwise known as r*, and its implications for capital markets.
R* is the rate of interest, adjusted for inflation, that provides economic equilibrium—neither restrictive nor stimulative. It is a construct driven by the economy, not policymakers. Nevertheless, it is tremendously important to central bank governors because r* determines whether current policy is accommodative or restrictive. Rates held too far away from r* could cause an economy to shrink or overheat.
There is no perfect way of estimating r*, and thus a wide variety of approaches have arisen. These methods include macroeconomic models, central bank estimates, surveys and market-implied proxies. Taken together, the average and median of these approaches suggests an r* level of 1% in the United States.
We review these approaches in detail within the paper and note that most estimates have broadly trended higher over the last three years.
This paper covers:
- What is r* and why does it matter?
- Various estimates of r*
- Factors that affect r*
- Our view of r* and how it impacts our capital market expectations
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. These risks are magnified in emerging markets.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.