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.
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| The Crucial Role of the Neutral Rate |
Estimating the Neutral Rate:
- 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.
Latest Update: Despite projections of inflation reaching the 2% target by 2026, Fed officials' December estimates kept the neutral rate at 2.9%. The topic wasn't discussed in their latest meeting minutes.
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| 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.
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