Some at the U.S. central bank may still be too optimistic abouthow high interest rates can rise in the longer run, based on newFederal Reserve Bank of San Francisco research.

San Francisco Fed economist Kevin Lansing started with a simplepremise: Estimates of the inflation-adjusted neutral interestrate—the one that neither stokes nor slows growth—track pretty wellwith the U.S. Congressional Budget Office's four-quarter growthrate of potential GDP estimates. Looking at the CBO's projectionsfor the next decade, he predicts “a very gradual rise” in theneutral rate, referred to as r-star in standard economic models,from near-zero in 2016 to about 1 percent in 2026.

“If the long-run value of r-star is indeed only around 1 percentor less, then the process of normalizing the federal funds rate mayend up being more gradual than the midpoint paths implied,” Lansingwrote. He notes that excluding high and low outliers, officials atthe middle of the Fed's June projection see a longer-run real rateof 1.15 percent.

The fact that the longer-run projection is low matters: it meansthat the Fed will have less room to cut rates to spur growth in thenext downturn than they have had in the past, and suggests thatthis hiking cycle will prove shallow.

Monetary policy is currently still easy, based on estimates ofthe neutral rate, because the federal funds rate targetrange—nominally between 0.25 percent to 0.5 percent—is below zeroonce you account for 1.6 percent core inflation. How high rates canclimb is an important consideration as the Fed, which next meets onpolicy from Sept. 20-21, contemplates how quickly and by how muchit should hike rates.

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