August 21, 2023
Despite the Federal Reserve raising interest rates to a 22-year high, the economy remains surprisingly resilient, with estimates putting third-quarter growth on pace to easily exceed its 2% trend. It is one of the factors leading some economists to question whether rates will ever return to the lower levels that prevailed before 2020 even if inflation returns to the Fed’s 2% target over the next few years.
At issue is what is known as the neutral rate of interest. It is the rate at which the demand and supply of savings is in equilibrium, leading to stable economic growth and inflation.
First described by Swedish economist Knut Wicksell a century ago, neutral can’t be directly observed. Instead, economists and policy makers infer it from the behavior of the economy. If borrowing and spending are strong and inflation pressure rising, neutral must be above the current interest rate. If they are weak and inflation is receding, neutral must be lower.
The debate over where neutral sits hasn’t been important until now. Since early 2022, soaring inflation sent the Federal Reserve racing to get interest rates well above neutral.
With inflation now falling but activity still firm, estimates of the neutral rate could take on greater importance in coming months. If neutral has gone up, that could call for higher short-term interest rates, or delay interest-rate cuts as inflation falls. It could also keep long-term bond yields, which determine rates on mortgages and corporate debt, higher for longer.
Every quarter, Fed officials project where rates will settle over the longer run, which is in effect their estimate of neutral. The median estimate declined from 4.25% in 2012 to 2.5% in 2019. After subtracting inflation of 2%, that yielded a real neutral rate (sometimes called “r*” or “r-star”) of 0.5%. In June, the median was still 0.5%.
That also happens to track a widely followed model
co-developed by New York Fed President John Williams that also puts neutral at 0.5%.
But while the median hasn’t changed, some officials’ estimates have been creeping up. In June, seven of 17 officials’ estimates were above 0.5% and only three were lower. A year earlier, eight were below 0.5% and two were above.
Why the neutral rate might be rising
Analysts see three broad reasons neutral might go higher than before 2020.
First, economic growth is now running well above Fed estimates of its long-run “potential” rate of around 2%, suggesting interest rates at their current level of 5.25% and 5.5% simply aren’t very restrictive.
“Conceptually, if the economy is running above potential at 5.25% interest rates, then that suggests to me that the neutral rate might be higher than we’ve thought,” said Richmond Fed President Tom Barkin. He said it is too soon to come to any firm conclusions.
That said, a model devised by the Richmond Fed, which before the pandemic closely tracked Williams’s model, put the real neutral rate at 2% in the first quarter.
Second, swelling government deficits and investment in clean energy could increase the demand for savings, pushing neutral higher. Joseph Davis, chief global economist at Vanguard, estimates the real neutral rate has risen to 1.5% because of higher public debt.
Former Treasury Secretary Lawrence Summers argued 10 years ago that slow population growth, inequality and a shortage of investment opportunities would create a glut of savings that depressed neutral. But he has recently suggested neutral has gone up because of higher deficits and the investment to transition to a lower-carbon economy.
Third, retirees in industrial economies who had been saving for retirement might now be spending those savings. Productivity-boosting investment opportunities such as artificial intelligence could push up the neutral rate.
And business investment depreciates faster nowadays and is thus less sensitive to borrowing costs, which would raise neutral. It is dominated by “computers and software, and much less office buildings, than it used to be,” Summers said during a lecture in May.
Similar debates are under way in other countries. Interest rates are more likely to settle at a level above, not below, the prepandemic norm, said Paul Beaudry, then-deputy governor of the Bank of Canada, in a June speech. He said he wanted to “help people be better prepared in the eventuality that we have entered a new era of structurally higher interest rates.”
Key Fed officials are less convinced
The debate remains far from settled.
In April, the International Monetary Fund predicted the U.S. real neutral rate would stay below 1% in coming decades because of aging populations and tepid productivity growth.
Williams said at a recent Fed conference he wouldn’t rule out surprises that raise neutral. But he expects an aging global workforce that boosts the supply of savings—and technological change that reduces the capital intensity of production—would eventually push it to, or even below, its prepandemic level.
Fed Chair Jerome Powell has in the past warned against setting policy based on unobservable estimates such as neutral, which he compared to navigating by the celestial stars.
Last December, he said the Fed would be careful about fine-tuning interest rates based on such estimates—for example, because falling inflation pushes real rates well above neutral. “I don’t see us as having a really clear and precise understanding of what the neutral rate is and what real rates are,” Powell said.
Some economists reconcile the debate by differentiating between short-run and longer-run neutral. Temporary factors such as higher savings buffers from the pandemic and reduced sensitivity to higher rates from households and businesses that locked in lower borrowing costs could demand higher rates today to slow the economy.
But as savings run out and debts have to be refinanced at higher rates in the coming years, activity could slow—consistent with a neutral rate lower than it is now.
This article was originally published in The Wall Street Journal on August 20, 2023, and written by Nic Timiraos. Image courtesy – WIN MCNAMEE/GETTY IMAGES
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