What Is the Fed’s Neutral Rate And Why Does It Matter?

In this article “What is the Fed’s Neutral Rate and Why Does It Matter?”, we are going to explore what is the Fed’s Neutral Rate of interest and why it matters. We are also going to see the concept associated with using the neutral rate in the formulation of monetary policy. For almost the past three months the talk of the nation is when the Federal Reserve is going to cut the interest rate. It is not only about the Fed’s interest rate cut but also regarding almost all major economies central banks’ interest rate cuts. 

The Central Bank of an economy determines and manages the economy by setting the interest rates at a level that encourages or discourages economic activities. All the efforts of the Central Bank revolve around the number that’s in the centre, though that rate does nothing, that is known as ‘Neutral’ interest rate or ‘Neutral rate of interest’. The deliberation concerning the neutral interest rate will affect when and to what degree rates will be eased. Now let’s get started 

What Is the Fed’s Neutral Rate And Why Does It Matter?

What Is the Neutral Rate?

As the name denotes ‘Neutral’ Rate of Interest is a short-term rate of interest at which the monetary policy is neither expansionary nor contractionary. It is also called the long-run equilibrium interest rate, natural rate, and r* (r-star as they are called by policymakers and economists). 

In 2018, the former U.S. Federal Reserve Vice Chair Lael Brainard in her speech, stated “the nominal neutral interest rate as the level of the federal funds rate that keeps output growing around its potential rate in an environment of full employment and stable inflation.” 

Why does it matter?

A neutral rate of interest is principally a guidepost for monetary policy. Neutral interest rate matters as it affects how the Federal Reserve estimates whether the interest rates it determines are stimulating or contracting the economy.

The Monetary policymakers, i.e. Central Banks, ensure that their policy measures are consistent with a neutral rate of interest (what they think/ estimate as). The number (i.e. Neutral rate of interest) guides the policymakers about where the interest rates should be fixed in the short term.

The policymakers make accommodative when the federal funds rate is below the neutral rate. When the monetary policy is accommodative, then the economy will tend to grow faster, inflation tends to increase and the unemployment rate will/should decline. 

If the policymakers make restrictive, by keeping the federal funds rate above the neutral rate, then economic growth will slow down, the inflation rate will decline or more muted and unemployment will increase. 

The main challenge confronting the Federal Reserve is the adept management of this process and achieving the optimal balance. 

It is to be remembered that monetary policy acts with a lag (i.e. time lag), therefore, policymakers have to make judgements on the stance and direction of policy well ahead. Keeping monetary policy accommodative for too long will also lead to imbalance and the creation of excess, which will be difficult to address – as the Federal Reserve need to “catch up” which often leads to recession. 

How Does The Fed Know What The Neutral Rate Is?

The neutral rate of interest is always mentioned in real terms, that is, with subtraction of inflation. A neutral rate of interest can only be estimated and cannot be observed directly.

The Federal Reserve doesn’t know what is neutral rate of interest is, but it has estimates. Policymakers always think about long-run trends in productivity where it is along with demographic trends. The Federal Reserve first began to publish its estimates of a neutral rate every quarter, from 2012. 

What Determines A Neutral Rate Of Interest?

The neutral rate of interest, in the long run, is mainly determined by demand and supply for savings. For instance: investors/firms require the supply of capital, which comes from households and other savers, to finance their investment (or) say to make new investments. To reach this equilibrium, total investment in the economy must be equal to available capital or savings. 

To meet this equilibrium, the interest rates need to be high enough to make savers save and low enough to incentivize the investors to borrow money for their investments from Banks. The interest rate which does bring savers and investment in equilibrium, in the long run, is the neutral rate of interest. There are other factors which can impact supply and demand for savings, they are 

1. Demographics: Demographics plays a vital role in savings and investment.  One of the main reasons to save is to prepare for retirement. An increase in life expectancy in advanced economies has increased the supply of savings driven by the neutral rate of interest. However, the lower fertility rates mean a slow-growing labour force. Therefore, the supply of capital and demand for investments also comes down. That pushes down the neutral rate of interest. Many researchers found that the demographic trends, in advanced economies, have a large downward effect on interest rates. 

2. Productivity Growth: Higher productivity is normally associated with more new investments. This means it increases in demand for capital, driving up the interest rates. It is found that, in recent years, the productivity growth has been quite low which driving down the neutral rate of interest.

3. Stagnation and Secular Stagnation: If an economy is stagnant then it will be reflected in a neutral interest rate. This is a hard/ complex situation for policymakers where they may keep the interest rate unchanged for too long, before making any decision.

Secular Stagnation, the term was coined by Alvin Hansen during the 1930s Great Depression. This term was revived largely by Former U.S. Treasury Secretary Lawrence Summers. According to this theory, it refers to a state of little or no economic growth. In simple, the economy is essentially Stagnant. The term secular in this theory means “long term”. 

In other words, Secular Stagnation states that an economy can experience long-term low-interest rates, low GDP growth, and high long-term unemployment. All this is possible due to a lack of aggregate demand. 

Summers says that savings have increased while the desire to invest has fallen due to changes in economic fundamentals. Mainly due to modern business – which requires less capital to function. As a result of this, he believes that the real interest rates will be low for a long period.

Recent Fed’s Take on Neutral Interest Rate

During a press conference after the FOMC meeting on January 31, 2024, the Fed Chair Jerome Powell stated “But, in addition, we don’t know with great confidence where the neutral rate of interest is at any given time. But that also doesn’t mean that we wait around for—to see, you know, the economy turn down, because that would be too late. So we’re really in a risk-management mode: of managing the risk—as I mentioned in my opening remarks—managing the risk that we move too soon and move too late. And I think to move, which is—which is where almost everyone on the Committee is—is in favor of, of moving rates down this year—but the timing of that is going to be linked to our gaining confidence that inflation is on a sustainable path down to 2 percent.”

Our Perspective

The Federal Reserve looks for a neutral rate of interest before making its policy decisions. Since, 2012, they started publishing about the neutral rate of interest, every quarter. From the Federal Reserve’s Chair statement, it is clear that the Federal Reserve is in no hurry to cut interest rates. However, it is also clear that the FOMC will go for an interest rate cut later this year. How long is too long to hold, only time can say.

Conclusion

Navigating the economic landscape requires understanding the Federal Reserve’s Neutral Rate. As discussions on interest rate cuts echo globally, policymakers grapple with achieving an optimal balance through careful decision-making for sustained economic stability.

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