Photographer: Graeme Sloan/Bloomberg
A shift is underway at the Federal Reserve in how to describe "neutral"—the interest rate level that neither stimulates nor restrains growth—as the agency debates how much higher to hike rates.
"Neutral" is an abstract concept, yet the stakes for setting it correctly are high: If the assessment of what rate is "neutral" is too low, Fed policy could provide too much stimulus to the economy as it fights inflation. If it's too high, policy will be more restrictive than planned. Either could result in a damaging policy error.
Recommended For You
The topic is moving up the policy agenda because in July, the Fed raised the top of its target range for the benchmark federal funds rate by 75 basis points (bps), to 2.5 percent, which Chair Jerome Powell noted met officials' estimate of the long-run neutral rate.
That move completed the first stage of the tightening cycle begun in March, when policymakers said they wanted to get to neutral "expeditiously" to cool surging inflation. Now, with officials beginning stage two of the campaign—as Powell laid out on August 26 in Jackson Hole, Wyoming—the discussion has turned to how much higher they now have to go and how long to stay when they get there.
That's also elevating the argument that neutral is currently higher than the Fed's long-run median estimate—which in June was 2.5 percent—indicating that rates need to be hiked further than otherwise. Powell has said that another unusually large increase could be on the table when officials next meet on September 20 and 21, depending on the data, and some policymakers want to see rates rise above 4 percent.
But estimates of neutral can vary widely. Just 39 percent of economists surveyed by Bloomberg in August agreed with the FOMC's view of neutral at 2.5 percent; their estimates ranged from 2 percent to 3.75 percent.
And it's a hard thing to talk about.
Powell was slammed for announcing after the July 27 rate increase that the move had lifted rates into the range of neutral. Critics argued the comment had fanned a rally in stocks as investors took it as a dovish hint that rates didn't have much higher to go.
Former Treasury Secretary Lawrence Summers, a paid Bloomberg TV contributor, said the remark was "indefensible" because 2.5 percent was not anywhere near neutral given the current high rate of inflation. Mohamed El-Erian, chief economic adviser to Allianz SE and a Bloomberg Opinion contributor, said, "The ZIP code for neutral is above where we are now," and at least 50 bps higher.
What Bloomberg Economists Say…
"There certainly seems to be a slight shift in where the Fed thinks the current 'restrictive' threshold would be. Powell's Jackson Hole speech said clearly that 2.5 percent would be far short of where 'restrictive' would be, given high inflation today."
— Anna Wong, chief U.S. economist
St. Louis Fed President James Bullard, among the most hawkish at the U.S. central bank, says the 2.5 percent estimate might make sense if the economy were on a balanced growth path with 2 percent inflation projected ahead—conditions contrary to the post–Covid-19 reality.
"That is not where we are today," Bullard said in an August 26 Bloomberg TV interview at Jackson Hole. "We've got all this inflation, and we've got a very strong labor market. So that's why it makes sense to go well above that to a recommended policy rate that's well above that."
San Francisco Fed President Mary Daly said neutral is "around 3 percent," and she'd like to get to a "restrictive" rate of more than that to push against demand. "We need to bridle back the economy a bit," she said in an August 18 interview with CNN International.
Neutral estimates are much less than inflation of 6.3 percent, as measured by the Fed's preferred gauge. Consumers expect 4.8 percent inflation over the next year and 2.9 percent over five to 10 years, according to the University of Michigan's survey.
For a business, that could make taking out a loan look like a bargain relative to inflation, therefore stimulating growth. "The current level of rates is not at neutral, given the configuration of inflation expectations," said Roberto Perli, head of global policy research at Piper Sandler & Co. "That's why the Fed thinks it has to keep tightening."
Fed officials, taking their lead from Powell, have spent most of the year talking about getting rates to neutral as fast as possible and being deliberately vague about what happens next. That's created a communication challenge.
"I think right now we are still in a somewhat accommodative state," rather than neutral, Atlanta Fed President Raphael Bostic told Bloomberg TV at Jackson Hole.
Fed officials are already reframing how they talk about neutral. During the July meeting, some participants commented that short-term neutral may be higher than their long-run estimate, according to minutes of the gathering.
Most Fed leaders have suggested they would be willing to err on the side of too-tight policy to ensure that they bring down inflation and avoid an undesirable rise in inflation expectations that could be hard to reverse later on. Some Fed officials have also begun talking more about "real rates"—or interest rates compared with inflation. Fed presidents Thomas Barkin of Richmond and Loretta Mester of Cleveland have both called for rates to move up so that real rates are positive—which has largely been accomplished now.
Even so, the "neutral" issue is thorny enough that Bostic said his head of research, David Altig, has urged him to avoid talking about it.
"The neutral language becomes sort of confusing and not all that useful," Altig said in a telephone interview. With short-term inflation, neutral is higher in the current environment. "The focus should not be arguing over numbers," he said.
© 2025 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.
