Subscribe to enjoy similar stories. Investors shuddered on Wednesday after Chair Jerome Powell suggested the Federal Reserve was ready to take a break from cutting rates—and that the total quantity of reductions might be shallower than previously thought. Powell has described recent rate reductions as an effort to recalibrate borrowing costs to a more “neutral" setting.
His framing raises a question that hasn’t been relevant until now: What, exactly, is “neutral" in the post-pandemic economy? The neutral rate of interest, or the rate that keeps the economy at full employment with stable inflation, can’t be directly observed. Instead, economists and policymakers infer it from the behavior of the economy. If borrowing and spending are strong and price pressures are rising, the current interest rate must be below neutral.
If they are weak and inflation is receding, rates must be above neutral. The debate over where neutral rests wasn’t particularly important earlier this year, because interest rates were at a level nearly all Fed officials deemed to be restrictive. That was intentional.
Officials raised rates aggressively in 2022 and 2023 to lower inflation by cooling down economic activity. But the question is front and center now because the Fed has cut rates by a full percentage point, or 100 basis points, and the economy appears to be in reasonably good shape. Like a captain who tries to avoid slamming into the dock as a boat nears its slip, central bankers could become more cautious in making cuts if they think they might be closer to their ultimate destination because the neutral rate has gone up.
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