With central banks worldwide now advancing through their easing cycles, investors are mulling where interest rates will ultimately settle. The right answer hinges on a key variable: the “neutral rate,” known in academic studies as R*. This is essentially the long-term equilibrium rate required to keep growth and inflation in balance over time.
Because monetary policy works with a long and variable lag, policymakers can’t observe R* in real time. Instead—in the face of challenges and uncertainties—they have to estimate it. Their central problem: determining whether neutral rates will converge back to pre-pandemic levels, or whether the recent inflationary breakout has pushed R* higher in some or all economies.
The solution? We think the European Central Bank (ECB) should concentrate on the underlying structural issues driving euro-area economies, stripping out recent forceful but transitory cyclical factors triggered in large part by the COVID pandemic and the energy shock.
Is R* Rising to a New Level?
Before the pandemic, academic models were clear that R* was trending downwards. Some of those same models, however, now suggest that R* may once again be rising.
Which model is the most informative? There’s a reliable guideline, in our view.
We believe it’s important to distinguish between the structural factors that are known to drive R* over the long term and temporary cyclical factors. For instance, a recent ECB study highlights the significant impact on R* of several cyclical factors including: the pandemic itself; the resulting supply-chain disruptions; the energy shock following the invasion of Ukraine; and governments’ stimulus packages.
While these factors contributed to the recent rise in the neutral rate, they’ve already reversed or are in the course of doing so, and are therefore unlikely to exert further upward pressure, in our view. Meanwhile, we don’t think anything has changed structurally in the eurozone to justify a significantly higher neutral rate than the pre-pandemic level.
Risks to R* Are on the Downside
We see the eurozone returning to pre-pandemic economic conditions—at best.
Real euro-area GDP growth is expected to remain similar to its pre-pandemic level, so output will continue to fall short of potential for the foreseeable future. In fact, we estimate the eurozone’s growth potential will likely fall from 1.2% to below 1% by 2028.
Source: European Commission
Adverse demographics are a big part of the eurozone’s growth problems: an aging population is constraining the labor supply. While net migration partly offsets the workforce decline, the positive impact for Europe is lower than in the US, and the overall euro-area trend is still down.
As in the US, expansionary fiscal policy in Europe has likely pushed the euro-area R* higher in recent years. But looking forward, we think European countries will have less scope for large-scale spending programs, and the positive impact on R* will fall away.
The market is currently pricing the ECB’s policy rate to settle at between 1.8% and 1.9%—a reasonable proxy for the market estimate of the neutral rate. That's within the range of pre-pandemic estimates but, in our view, too close to the upper bound and with room to move lower.
With euro-area potential growth likely to continue slowing, fiscal policy remaining stable and inflation falling, we think both R* and the end-point of the ECB’s easing cycle will be lower than the market currently forecasts (Display).
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.
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