Demystifying the Neutral Rate: A Guide to the Fed's Monetary Policy

𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 Updated content from Oct 9, 2024𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 𓆝

The neutral rate is the interest rate that doesn't stimulate or slow down the economy.  Investors should watch the neutral rate and the pace at which rates approach it:

• The Fed predicts a neutral rate of 3.4% in 2025, higher than their previous estimate of 2.5%.
• The market generally expects a neutral rate between 2.5% and 3.5% at this moment.
• The Arora Report disagrees and believes the neutral rate will be higher, likely in the range of 3.25% to 4.25%. They base this on the assumption that economic and geopolitical factors remain relatively stable.

𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 Updated content from August 23, 2024𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 𓆝

On August 23, 2024, the Chair of the Federal Reserve said: “The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.” 

Chief Market Strategist James E. Thorne at Wellington-Altus Private Wealth commented on Powell’s announcement by saying, 

“Advocates for slower rate cuts may not fully recognize that cuts typically have long lags, often exceeding 18 months. For instance, a 25 basis point cut in September would likely take effect by January 2026. The Fed needs to reach the neutral rate (r*) quickly, which implies the necessity of front-loading rate cuts. The sooner we achieve r*, the better it will be for the economy. Once r* is reached, they can be patient. FYI, r* is in the 2.5-3% range.”

𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 𓆝Original content from February 26, 2024𓆝 𓆟 𓆞 𓆝 𓆟 𓆞 𓆝

What's Neutral Rate?

The Fed's "neutral" rate, also called the natural rate of interest or r-star , is the theoretical interest rate at which the economy operates at full employment with stable inflation.  The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.

Here's a breakdown of why it matters:

• Monetary Policy Gauge: It acts as a benchmark for the Federal Open Market Committee (FOMC), the group that sets the federal funds rate , to gauge the stance of monetary policy.
• Neither Stimulative nor Restrictive: When the federal funds rate is below the neutral rate, it's considered accommodative , stimulating the economy. Conversely, a rate above the neutral rate is considered restrictive , aiming to slow down economic growth.
• Balancing Growth and Inflation: The Fed tries to maintain the federal funds rate close to the neutral rate to achieve a Goldilocks scenario - sustainable economic growth without excessive inflation .

The neutral interest rate is a crucial concept right now because central banks want to raise rates just enough to tame inflation without triggering a recession. This delicate balance makes the ongoing debate about the neutral rate highly influential. The conclusions of this debate will determine when central banks begin to ease rates and how much tightening is considered enough.

The Crucial Role of the Neutral Rate

Estimating the Neutral Rate:

Determining the exact neutral rate is challenging as it's influenced by various factors, including:

• Productivity growth: Higher growth potentially leads to a higher neutral rate.
• Demographics: An aging population can put downward pressure on the neutral rate.
• Global factors: International economic conditions can also play a role.

Estimating the neutral rate, though imprecise, is crucial for the Fed's policy decisions. Central bankers believe long-term trends like productivity and demographics influence it. Their estimates, initially high (4.25% in 2012), have steadily decreased to 2.5% since 2019.

Latest Update:  Despite projections of inflation reaching the 2% target by 2026, Fed officials' December estimates kept the neutral rate at 2.8%. The topic wasn't discussed in their latest meeting minutes.

Effective Federal Funds Rate Chart (source: St Louis Fed)

Decoding the Difference: Neutral Rate vs. Effective Federal Funds Rate

The neutral rate of interest refers to the real interest rate expected to prevail when the economy is at full strength and inflation is stable. It represents the rate that neither stimulates nor restrains economic growth. 

Here’s why the neutral rate and the actual Effective Federal Funds Rate might differ:

• Neutral Rate:
• The neutral rate is estimated to be around 2.9% in December 2023.
• It’s the rate that balances economic growth without causing inflationary pressures.
• The Federal Reserve aims to set monetary policy close to this neutral rate.
• Effective Federal Funds Rate:
• As of February 23, 2024, the Effective Federal Funds Rate stands at 5.33%.
• This rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.
• The Federal Reserve uses open market operations to influence this rate.
• Divergence Reasons:
• The actual federal funds rate can diverge from the neutral rate due to various factors:
• Economic Conditions: If the economy is growing too fast or too slow, the Fed adjusts rates accordingly.
• Inflation: If inflation is rising, the Fed may raise rates to cool economic activity.
• Recession Risks: The Fed may temporarily set rates above or below the neutral rate to respond to economic conditions.

In summary, the difference between the neutral rate and the actual federal funds rate reflects the Fed’s efforts to balance economic growth and inflation while adhering to its dual mandate.  

When the federal funds rate is below the neutral rate, it's considered accommodative , stimulating the economy. Conversely, a rate above the neutral rate is considered restrictive, aiming to slow down economic growth.

References

1. Measuring the Natural Rate of Interest - FEDERAL RESERVE BANK of NEW YORK
2. The Fed - Longer-Run Neutral Rates in Major Advanced Economies
3. What’s the Fed’s ‘Neutral’ Rate and Why Does It Matter?
4. Federal Funds Effective Rate