DR.CHENJIAZI ZHONG

The concept of a Neutral Policy Rate has a very specific meaning in contemporary central bank practice. The neutral policy rate is the short-term interest rate consistent with full employment, inflation equal to the central bank’s inflation target and inflation expectations that are well-anchored to the inflation target. The neutral policy rate is related to the neutral real policy rate: neutral policy rate = neutral real policy rate + inflation target.

Federal Reserve officials have cited a number of reasons why the neutral real policy rate several years in the future may be below the appropriate neutral policy rate that prevailed before the crisis, including:

• Slower growth in potential output
• Demographics
• Higher precautionary savings
• Higher global savings
• Slow credit growth

Investing in the New Neutral world will require getting the business cycle right as well as getting the neutral policy rate right:

• Opportunities in global rates: The past will not be prologue; there will be opportunities in hard duration, exposure directly to interest rates.
• Opportunities in global equities: The New Neutral will support valuations, and it will support higher equity multiples. If bond yields imply that futures are about right, then so are current equity multiples, which may appear elevated to those not taking into account a new neutral rate for discounting cash flow.
• Opportunities in global credit: Seek out secular winners, one company at a time. For those who invest in bottom-up research on securities, sectors, companies and countries, a multi-speed world will offer the opportunity for abundant rewards.
• Opportunities in emerging markets: Forget the acronyms, do the homework. In a multi-speed world, loading up on equally weighted portfolios BRICs will no longer make sense, and again, bottom-up research on companies and countries brings potential rewards.
• Opportunities in currencies: The U.S. dollar as well as the currencies of the economies likely to be secular winners.
• Opportunities in asset allocation: Opposites attract. One of the new financial correlation relationships to survive the crisis is the negative correlation between equity risk and interest rate risk. Bond allocations have been and should continue to be natural and efficient diversifiers across a broad range of asset allocation strategies.