Fed’s Debate About ‘Neutral’ Is Mostly an Exercise

The Federal Reserve’s internal debate about the “neutral” real rate of interest is heating up.

The neutral rate, or r-star, is the inflation-adjusted policy stance that neither stimulates nor restrains the economy. The rate is impossible to observe in real time, yet policymakers have been subtly revising up their estimates of what they think it might be. And some observers are making sensational claims about the significance of the moves.

Undoubtedly, it’s a big deal for monetary policy wonks but probably not for everyone else.

Consider the tea leaves from Wednesday’s monetary policy decision, in which the Fed’s rate-setting committee decided to hold the target range for the federal funds rate steady at 5.25% to 5.5%. As part of the data dump, policymakers updated their Summary of Economic Projections, showing that they thought interest rates would have to stay higher than previously expected in 2024 and 2025. Even more inflammatory, some policymakers revised higher their estimates of long-run rates. Although the median forecast remained unchanged at 2.5% (or 0.5% adjusted for the 2% inflation target), the central tendency now suggests that long-term neutral is about 2.5% to 3.3% in nominal terms, up from 2.5% to 2.8% in June projections and 2.3% to 2.5% at the end of last year.1

Where's Neutral