Current Fed governor Christopher Waller, the frontrunner for the next Fed chairman, said on Friday that interest rates are likely to be higher than the low rates of the 2010s in the future economic cycle, but that has not yet been determined.

In his speech at the economic conference in Reykjavik, Iceland, Waller focused on the debate over the so-called neutral interest rate (R-Star). The issue sounds technical, but it has important implications for the Fed's long-term policy.

R-Star, usually written as Renewal, is a theoretical concept in economics. Unfortunately, for economists and market participants, neutral interest rates are not as immediately measurable as bond yields or unemployment, but can only be observed to some extent in hindsight.

R* refers to the inflation-adjusted real interest rate at which savings and investment demand in the economy are balanced. Neutral interest rates will neither stimulate nor curb growth and inflation. In other words, this means that monetary policy is neither tight nor loose.

Waller saidArcadestool"R* can be seen as the level of the real federal funds rate after all cyclical fluctuations in the economy have been removed, including the short-term policy tightening or easing sometimes needed to restore employment and inflation to FOMC targets."

Over time, the economy should be balanced and the real federal funds rate should be equal to R *.

In their latest economic forecasts in March, Fed officials set the median estimate of the long-term federal funds rate at 2.Arcadestool.6%, 0.1 percentage point higher than the forecast three months ago. Minus the central bank's 2% inflation target, the neutral interest rate is estimated at 0.6%.

The real yield on 10-year Treasuries can act as a proxy for neutral interest rates because it represents the market's collective view of the direction of long-term interest rates. Waller points out that this indicator has continued to decline over the past four decades, indicating that R* is declining. The real yield on the current 10-year Treasury note is about 2 per cent.

Recently, many economists and commentators believe that the neutral interest rate in the US economy may be higher today than it was before the COVID-19 epidemic. This suggests that once the Fed starts to cut interest rates, it will not cut rates as much as it did in the past.

Theories about why the economy can balance at higher interest rates include faster productivity growth, high structural inflation due to the return of production to the US, green transitions and an ageing workforce; and a riskier and more uncertain world caused by geopolitical instability and frequent natural disasters, which could push bond yields higher.

Waller is not sure about this. He points out that the long-term decline in real yields on 10-year Treasuries is driven by forces that largely still exist.

"as a decision maker, it is important to understand what drives any change in R so that it can be used to guide my policy review, rather than intuitively asserting that R is rising," he said. There must be a reasonable economic explanation for its rise or decline. "

Mr Waller points out that the liberalisation and globalisation of capital markets has made foreign buyers one of the largest holders of US Treasuries; an ageing population that values risk-free income assets; and stricter financial regulation that drives banks to hold more Treasuries. These factors have led to demand outstripping supply over the past 40 years, pushing down 10-year Treasury yields and R*.

He believes that these demand-side dynamics will not be reversed, but he points out that the large amount of borrowing made by the US government to finance the persistent budget deficit is unsustainable. "if supply growth in Treasuries starts to outpace demand, it will mean lower prices and higher yields, putting upward pressure on R*."

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

At its meeting from April 30th to May 1st, the FOMC unanimously voted 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 so since July. Policymakers also announced that they would reduce the pace of the Fed's quantitative tightening program.

Friday's interest rate futures pricing showed that the target for the federal funds rate was less than 1 per cent likely to change at the next meeting of the FOMC on June 11-12. The market thinks the probability of cutting interest rates in September is about 50%.