Does the Neutral Rate Really Exist?
In the world of central banking, the "neutral interest rate" is like the mythical unicorn that is said to bring balance and harmony to the economy. However, estimating and implementing the neutral rate is far from a fairy tale. Policymakers now believe that the neutral rate has risen due to factors such as higher debt loads and supply chain stressors. Fed Chair Jerome Powell recently stated that the neutral rate was "probably significantly higher" following the pandemic, while ECB executive board member Isabel Schnabel has been arguing for an upward trend.
Massive investments in areas like clean energy and defence, along with supply chain setbacks, may persistently impact the natural rate of interest. But the uncertainty surrounding the neutral rate has increased, with estimates varying widely. For the US, the median FOMC voter places the neutral (nominal) rate at around 2.5%, but within a range of 2.3% to 3.3%.
Moreover, the quest for a single optimal rate is complicated by the fact that inflation rates can vary significantly across different segments of the population. The narrowing gap between the Fed funds rate and the neutral rate has significant implications for monetary policy. Overshoot, and the economy could stall; undershoot, and inflation could spiral out of control.
In practice, estimating and adhering to the neutral rate becomes a politically loaded art rather than a simple hard science. With the US presidential election set for 5 November and the next FOMC meeting scheduled thereafter, the Fed's decision on interest rates will come after voters have cast their ballots. This timing, together with the fact that there still seems to be a gap between the actual rate and the neutral rate could insulate the central bank from accusations of political influence at this stage, but the pressure to get it right remains high. Central bankers must balance economic growth, inflation, and the disparate impacts on different segments of society, all while navigating intense scrutiny.
While the neutral interest rate may seem as elusive as a mythical creature (or a crowd of them), its pursuit remains crucial for economic stability. Central bankers must balance a multitude of factors and competing interests. With the election soon in the rearview mirror, the Fed may have a bit more room to manoeuvre, but staying politically neutral is a challenge in itself. After all, in a world where even mythical creatures can be politicised, can the Fed really avoid taking sides? The stakes are high, and the Fed's quest for neutrality may be as challenging as its search for the neutral rate. Regardless, like any good unicorn hunter, they must press on, knowing that the stability of the economy hangs in the balance.
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