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For Fed, the ‘Neutral Rate’ Is Crucial, and Unknown

The Marriner S. Eccles Federal Reserve building in Washington, D.C., US, on Tuesday, Aug. 23, 2022. The Federal Reserve chair’s speech this week at the Jackson Hole symposium is expected to offer clues on the Fed’s tightening path, with hedge funds making record bets that the US central bank will stick to its hawkish script. Photographer: Graeme Sloan/Bloomberg (Bloomberg)

Central banks seek to manage economies by setting interest rates at levels that speed up or slow down things like car purchases and construction projects. But the enterprise revolves around a number that’s far more abstract — the rate that does nothing at all, also known as the neutral interest rate. Right now, it’s an important guidepost because most monetary policy makers are trying to set rates high enough to bring down inflation -- but not so high as to guarantee a recession. Another number getting more attention than usual is the US Federal Reserve’s terminal rate -- the rate that marks the peak of a tightening cycle

1. What is a neutral interest rate?

In theory, the neutral interest rate is the rate at which monetary policy is neither stimulating nor restricting economic growth. As Fed Vice Chair Lael Brainard put it in a 2018 speech, it’s the level “that keeps output growing around its potential rate in an environment of full employment and stable inflation.” (The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.)

2. Why is it an important number?

There are two reasons. In the long run, central banks want their policy to match what they think the neutral rate is. But it also guides their thinking about where interest rates should be in the short term. If the economy is operating below full capacity, they want to make sure interest rates are below neutral levels so that they’re helping boost economic growth. Conversely, if inflation is too high, they want to keep interest rates above neutral levels in order to slow things down.

3. How does the Fed know what it is?

It doesn’t, but it has estimates. Central banks tend to think that long-run trends in things like productivity and demographics dictate where it is. In 2012, when Fed officials first began publishing their estimates of the neutral rate on a quarterly basis, the median Federal Open Market Committee participant pegged it at 4.25%. Over the ensuing years, that estimate was continually marked down; in July it stood at 2.5%.

4. What do Fed officials say?

Fed officials have been raising rates quickly this year in a bid to bring inflation -- which has reached its fastest pace since the early 1980s -- under control. In July, the target range for the federal funds rate reached 2.25-2.5%. That set the stage for the next phase of the tightening cycle, as officials signaled that they would go on to raise rates above that level with the hope that doing so will slow down the economy and put downward pressure on inflation. In September, they raised the fed funds rate to a range of 3 to 3.25% and indicated it was likely to reach 4.4% by the end of the year.

5. How has that been received?

Whether a 2.5% federal funds rate can be considered neutral or not in 2022 has led to some spirited debate. Former Treasury Secretary Lawrence Summers in July described it as “indefensible,” while Jason Furman, who led the Council of Economic Advisers in former President Barack Obama’s White House, took the other side. Former New York Fed President William Dudley said he’d be “a bit more skeptical” that 2.5% is neutral given uncertainty around the estimates. Some Fed officials have also begun talking more about “real rates” — interest rates with inflation factored in. During the July meeting of the Fed’s policy making committee, some participants commented that short-term neutral rates could be higher during this period of adjustment from the disruptions from war and the pandemic than their long-run estimate, according to minutes of the gathering.

6. How do estimates of neutral change what the Fed does?

That’s not entirely clear. Even if Fed officials think 2.5% is a neutral level for interest rates in the long run, they’re not betting the farm on it. They know they’re dealing with unusual circumstances, including the pandemic’s disruption of supply chains and the shockwaves from Russia’s invasion of Ukraine. As Fed Chair Jerome Powell put it in his Aug. 26 speech at Jackson Hole in Wyoming: “In current circumstances, with inflation running far above 2% and the labor market extremely tight, estimates of longer-run neutral are not a place to stop or pause.” Eventually, once inflation comes back down, the Fed may try to navigate back to the neutral rate. 

7. What about the terminal rate?

When Fed officials published quarterly projections in September, the median estimate by FOMC participants had the funds rate peaking at 4.6% in 2023, before returning to 3.875% in 2024 and 2.875% by late 2025. Later in the year, however, Fed officials suggested that the terminal rate could be higher, perhaps at or above 5%. By contrast, the terminal rate during the bout of high inflation that started in the 1970s was 20% -- and produced one of the century’s deepest recessions. Fed officials who want to avoid a repeat are hoping that holding rates steady at levels well above neutral over the next few years will do the trick.

• A Bloomberg News article on the Fed and the debate over the neutral interest rate.

• A QuickTake on the Fed’s search for a path to a “soft landing.”

• QuickTakes on recessions and inflation and “quantitative tightening.”

• What Summers, Furman and Dudley had to say about the neutral rate.

• A Dallas Fed primer on the neutral interest rate.

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