Fed officials stress that their decisions are dependent on economic data, firm indications of the economy’s health and possible direction. But there’s one key concept guiding the Fed that Chair Jerome Powell says is “theoretical” and “can’t be directly observed.”
That’s the so-called “neutral rate of interest,” a level of interest rates that neither stimulates nor dampens the economy. The Fed’s main tool is its key interest rate, which influences borrowing costs across the economy, and it functions by either boosting demand, if rates are low, or by cooling it, if rates are elevated. That depends on whether the Fed is dealing with high inflation, which prompts the Fed to slow the economy, or high unemployment, which forces the Fed to do the opposite.
Economists describe the neutral rate of interest as theoretical because it depends on many, many factors that render it too imprecise — such as population growth, productivity, savings behavior, any structural changes in the economy and so on, in addition to the effects of borrowing costs.
With inflation down substantially from a four-decade peak reached in 2022, and just a whisper away from the Fed’s 2% goal, the Fed has shifted more attention to America’s job market, which has steadily weakened over the past few years. It remains in good shape, but Powell telegraphed in September that the Fed is committed to maintaining its strength, avoiding any deterioration.
Fed officials have said they think borrowing costs are still at restrictively high levels, which puts the labor market at risk. Now it’s a matter of how fast the Fed wants interest rates to go back to that neutral rate of interest. That, of course, also depends on inflation. Some officials have said they feel no urgency to pare back rates.
“I’m not in a rush to get to neutral,” Atlanta Fed President Raphael Bostic said last month at an event in Jackson, Mississippi. “We must get inflation back to our 2% target, and I don’t want us to get to a place where inflation stalls out because we haven’t been restrictive for long enough. So I’m going to be patient.”
