With the Federal Reserve's interest rate cut now a done deal, the market's focus has shifted to "where will interest rates go?" and where will the true R* (neutral interest rate) settle?

Currently, the general consensus in the market is that the neutral interest rate may be higher than before the pandemic, but there is no consensus on how much higher, and the level at which interest rates ultimately stabilize is crucial for the U.S. economy.

On Monday, former Federal Reserve Vice Chairman and Pimco Global Economic Advisor Richard Clarida pointed out in an article in the Financial Times that the neutral policy interest rate may rise from the 0.5% before the pandemic, but this increase will be moderate. Others believe that the neutral real interest rate may need to be significantly higher than the Fed's current forecast of around 1%.

At the same time, Clarida noted in the article that it is more noteworthy that the U.S. Treasury yield curve will steepen, with the current term premium being positive and likely to continue to rise.

The neutral interest rate will be higher than before the pandemic.

The so-called R* refers to the interest rate range that allows the economy to achieve the "Goldilocks" scenario, that is, the economy is neither too hot nor too cold, just right, and can maintain price stability and maximum employment, which is crucial for understanding the evolution of monetary policy in the coming years.

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Richard reviewed the neutral interest rate levels before 2008 and in 2018:

Looking back at 2018, inflation had reached the 2% target, and the economy was operating at full employment. That year, the Federal Reserve raised the federal funds policy interest rate to 2.5%, with the real interest rate at 0.5%, which many considered to be the "neutral" level of monetary policy.In comparison, prior to the global financial crisis, the average real policy interest rate was around 2%, with the nominal federal funds rate close to 4%. Fast forward to today, the Federal Reserve's dot plot suggests that once inflation stabilizes at 2% and the labor market is fully employed, the target for the federal funds rate is around 3%.

Richard believes that the neutral interest rate will be higher than pre-pandemic levels, but likely only moderately so, while other analyses anticipate a higher neutral rate:

Others argue that the neutral real interest rate may need to be significantly higher than the approximately 1% currently forecasted by the Federal Reserve, as well as the levels reflected in current financial markets. They posit that the factors that have been suppressing interest rates prior to the pandemic are reversing, coupled with a worrisome fiscal outlook for the United States, with deficits and debt continually rising. The U.S. may also be on the cusp of an AI-driven productivity boom, which could increase the demand for loans by American companies.

Focus on the steepening yield curve, term premiums will continue to rise

However, Richard believes that what is more noteworthy is the trajectory of the U.S. Treasury yield curve:

The inversion of the U.S. Treasury yield curve is not the new normal, but rather a rarity. Relative to the "front-end" interest rates set by the Federal Reserve, the U.S. yield curve will adjust by steepening in the coming years to balance the substantial influx of demand and supply for U.S. fixed income.

Given the massive and growing supply that the bond market will have to absorb in the coming years, yields may be higher than the levels seen in the years preceding the pandemic. However, most of the adjustment will occur through the slope of the yield curve, rather than a significant increase in the federal funds rate itself.

Richard further points out that term premiums will also continue to increase:The current term premium is positive and may continue to increase. This is because bond investors require a higher term premium to absorb the influx of bonds that will enter the market.