Federal Reserve Officials Search for the Elusive ‘Neutral’ Interest Rate
To investors, Chairman Jerome Powell’s comments appear contradictory.
The word “neutral” is usually as boring as beige. But not when it’s coupled with “interest rate.” Stocks leaped on Nov. 28 when Federal Reserve Chairman Jerome Powell opined that short-term interest rates were just below their “neutral” range. Investors concluded that the central bank was almost done raising interest rates, sending the Dow Jones industrial average up 618 points, or 2.5 percent.
Powell, 65, is a seasoned Washington lawyer, ex-Treasury official, and former private equity executive who served on the Fed’s Board of Governors for six years before President Trump elevated him to chairman in February. He knows all about message discipline. Yet in alluding to the neutral interest rate, he waded into one of the biggest controversies in economics. Even within the Fed’s Federal Open Market Committee (FOMC), which sets the target for the benchmark federal funds rate, there’s deep disagreement on the topic.
One handy definition of the neutral interest rate is the rate that you’d want when the economy is at Goldilocks perfection. In that situation, there’s no need to raise interest rates to dampen inflation pressures or lower them to encourage companies to hire. Keeping the rate at neutral is like driving with cruise control—you can keep your foot off the gas and off the brake.
In practice, things are considerably more complicated. The economy is rarely at that ideal speed, and even when it is, the Fed can’t be sure if the interest rate prevailing at the time is neutral. Maybe it’s too low and inflation is about to accelerate, or maybe it’s too high and unemployment is about to rise.
Moreover, the neutral rate changes over time. The real, or inflation-adjusted, short-term rate “that would prevail absent transitory disturbances” fell from 3.2 percent in 2000 to 0.3 percent in 2013 before rebounding to 0.8 percent in September, according to estimates by John Williams, now president of the Federal Reserve Bank of New York, and Thomas Laubach, an economist for the Federal Reserve Board in Washington.
From 2008 until recently, identifying the neutral interest rate was of mostly academic interest. The U.S. economy was so weak that the Fed wanted rates that were stimulative. Now, with unemployment well under 4 percent and inflation close to the Fed’s target of 2 percent, Powell and the rest of the FOMC need to figure out how high rates need to get before they cease to be stimulative and become neutral.
The uncertainty over what rate level is neutral is apparent in the “dot plot”—the chart of FOMC members’ expectations for interest rates over the next few years. Each dot represents one member’s forecast. In September, the dot plot showed a range of a full percentage point—2.5 percent to 3.5 percent—in members’ estimates of the appropriate level of the federal funds rate in the “longer run.” That’s pretty much the same thing as the neutral rate, because the “longer run” refers to a hypothetical state in which the economy is at equilibrium.
There’s even more disagreement over where rates should be in the shorter run: Members’ estimates of the appropriate fed funds rate for the end of 2021 range from a low of just over 2 percent to a high of just over 4 percent. The high end of the range means that at least some members think the central bank will need to hike rates to a level that’s restrictive—cooling off the economy to quell inflation—before shifting to neutral.
Given the confusion, Powell has been warning Fed watchers against fixating on any particular value for the neutral rate. Speaking at a major monetary policy conference in Jackson Hole, Wyo., in August, he said the Fed would pay attention to data, not just economic models. He praised his predecessor, Alan Greenspan, for letting the economy grow in the 1990s by keeping interest rates low even though models (incorrectly) predicted that inflation was about to break out.
But then Powell put the neutral rate back in the spotlight on Oct. 3 when he said, “We’re a long way from neutral at this point, probably.” The perception that the Fed had a lot more rate hikes in store helped trigger a 10 percent decline in the S&P 500 stock index over the following month and a half. Then in his speech in November he appeared to contradict himself, saying interest rates “remain just below the broad range of estimates of the level that would be neutral for the economy.” This time stocks rallied, on speculation that the Fed might be ready to hit pause on rate hikes.
Some Fed watchers say the October Powell was not as hawkish, nor the November Powell as dovish, as market participants concluded. For one thing, the current target range for the federal funds rate is 2 percent to 2.25 percent. That’s not much lower than the bottom of the range of longer-run estimates in the dot plot. If that narrow gap is what Powell was referring to in November when he said rates were “just below the broad range of estimates,” then he was just stating a fact, not hinting at future policy. “Powell’s description contained little news, in our view,” Goldman Sachs Group Inc. economists Daan Struyven and Jan Hatzius wrote on Nov. 30.
These are jittery days, though, as Trump assails the Fed for raising rates. Unless Powell decides to surprise markets again, he’ll have to redouble his efforts to paint in shades of beige and be neutral on neutrality.