What’s the Fed’s ‘Neutral’ Interest Rate? Why Does It Matter?

(Bloomberg) -- Central banks seek to manage economies by setting interest rates at levels that encourage or discourage activities such as car purchases and construction projects. These efforts revolve around a number that’s right in the middle — the rate that does nothing at all, also known as the neutral interest rate. It’s an important guidepost right now because monetary policymakers across advanced economies are cutting rates as the inflationary years of the pandemic period draw to a close, but they’re doing it with some caution as new inflation risks simultaneously emerge. That means the debate over the neutral rate will influence how long central banks will keep cutting interest rates.

What is the neutral interest rate?

In theory, the neutral interest rate — or, as it’s usually recorded in economic models, r*, pronounced “r-star” — is the rate at which monetary policy is neither stimulating nor restricting economic growth. As former US Federal Reserve 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.)

Why is it an important number for central banks?

In the long run, central banks want their policy to be consistent with what they think the neutral rate is. The number 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.

How does the Fed know what the neutral rate is?

It doesn’t, but it has estimates. Central bankers tend to think that long-run trends in 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 figure provided by members of the Federal Open Market Committee (the Fed body that determines monetary policy) was 4.25%. Over the ensuing years, that figure dropped, and from 2019 to 2023 it hovered around 2.5%. In 2024, however, it has edged higher every quarter, to 2.875% as of September.

How do estimates of the neutral rate affect what the Fed is doing?

The Fed wants to hew closely to the neutral interest rate due to a combination of factors: The US economy is doing well, which reduces the need to fuel it with significant rate cuts. But inflation is largely under control, which means there’s probably little need to keep rates high, either. In other words, there’s not a strong reason to stimulate or restrict the economy. 

As a result, the Fed’s recent strategy reflects an effort to aim for the estimated neutral interest rate without dipping below it. The Fed took a relatively aggressive approach to cutting rates in early fall, when rates were well above neutral, implementing a larger-than-usual half-point reduction in September. But now, with the rate set to end the year at 4.33% — just 1.5 percentage points above the Fed’s estimate of neutral — officials say they can slow down the pace of cuts. “We can afford to be a little more cautious as we try to find neutral,” Fed Chair Jerome Powell said at a New York Times conference on Dec. 4.

How does uncertainty over the neutral rate affect investors? 

The debate over where neutral lies is becoming increasingly important for bond-market investors. Yields on Treasury bonds tend to follow the Fed’s benchmark interest rate. If the Fed’s estimate of neutral keeps going up, and officials therefore don’t cut rates much further, investments in bonds could result in losses. But if the Fed’s estimate of neutral stays below 3% and rate cuts continue, bets on bonds stand to make a lot of money. Fed officials will publish new estimates of the neutral rate on Dec. 18.

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