The neutral interest rate, explained – and why the unknown level is important for your money

The Federal Reserve’s September meeting will likely mark a new era for monetary policy, and it could be when things start to feel really bad for the US economy — by design.

If officials raise rates by about three-quarters of a point this week, the Fed’s benchmark federal funds rate will cross a crucial line for the first time in more than a decade: an economic red zone known to Fed officials. monetary policy as “the neutral rate of interest.”

The threshold is illusory, even for Fed policymakers. It’s constantly on the move, has fallen nearly 2 percentage points since officials began releasing their estimates, and is more of a guess than an absolute.

But for consumers and businesses alike, the implications are clear: once rates get past that point, the Fed thinks rates are no longer stimulating the US economy. Instead, they actively slow down activity.

Things could get worse before they get better in the Fed’s race to slow the economy

It could give Americans the impression that things could go from bad to worse. Certainly, many feel they have already witnessed a downturn in the economy. The S&P 500 is down more than 19% since the start of the year, economic activity has shrunk for two straight quarters, the once-strong housing market is coming to a halt and consumers have never felt so badly towards the financial system, according to a sentiment gauge from the University of Michigan.

But beyond these rate-sensitive sectors, the US economy still looks good on paper. This is increasingly becoming everyone’s problem – both for central bankers and consumers who are faced with the reality that interest rates probably have to rise much more than expected before the searing inflation begins. to calm down.

Businesses have almost two open jobs for every unemployed person and have added nearly half a million jobs on average over the past 12 months. Even with announcements of layoffs in the tech and financial services sectors, Americans don’t seem to have to search for a new job very long, and unemployment is at its lowest level in nearly half a century.

Price pressures, however, are showing worrying signs of warming beyond high food and gasoline prices, even as the Fed raises interest rates at the fastest pace in four decades. Rent in August, for example, soared at the fastest rate since August 1986, while medical care, tuition, insurance, appliances and services also soared.

“Outside of the housing market, there’s not a huge amount of evidence that rate hikes to date are slowing the economy,” says Steve Friedman, macroeconomist and managing director at MacKay Shields, a former vice chairman of the Fed. from New York. “That raises the question of whether they should push rates even further into restrictive territory.”

Interest rates are rising faster than many businesses and consumers have ever seen

Technically, the Fed’s neutral interest rate is the point at which rates no longer stimulate economic growth, but they don’t restrict it either. In normal times, it is meant to be a barricade of “safe” rate setting, reflecting the short-term interest rate consistent with maintaining both stable prices and full employment – ​​the Fed’s dual mandate. Policy makers jump to both sides of the line when they want to speed up or slow down the economy.

If the economy faces a crisis or needs a boost, officials will likely ensure that interest rates are below this threshold. This makes money cheap, encourages consumers to spend more and gives businesses the means to grow, thereby strengthening the employment side of the Fed’s mandate.

But rates have been in this position since the aftermath of the financial crisis, meaning consumers and businesses don’t have much recent memory living in the environment ahead of them.

When rates rise above neutral, the Fed is explicitly trying to slow spending, investment, and hiring. They will probably do it for one reason: To cool inflation.

“The idea of ​​neutral is a bit squishy, ​​but what we do know is that inflation is far too high, the labor market is far too tight and interest rates are still too low to solve the problem. either of these issues,” says Greg McBride, CFA, Bankrate’s chief financial analyst.

Where is the neutral rate?

The so-called neutral rate is currently estimated at 2.5%, at least according to Fed officials’ median estimate from their June projections. At the same time, however, estimates range from 2% to 3%, depending on Fed models.

It highlights the main issue: neutrality needs to be debated, taking into account a wide variety of factors, including productivity, trend growth, inflation expectations and financial conditions. For this reason, officials often like to say that neutrality is something that is inferred rather than known – and that’s just another factor that makes the Fed’s job difficult.

The Fed has certainly learned that getting it right can be difficult since it began publishing its neutrality estimates in January 2012. At the time, neutrality was estimated at 4.3%. Officials gradually lowered that estimate – until June 2019, when 2.5% officially became the goal post.

Rates in 2018 moved closer to the Fed’s neutral estimates. The federal funds rate peaked at 2.25-2.5% after the central bank’s ninth and final rate hike in December 2018, but tepid inflation amid the lowest unemployment rate in half a century tested officials’ belief that rates would neither slow nor accelerate the economy once they hit 2.8 percent.

In June 2019, officials would cut interest rates in three consecutive meetings starting a month later, saying the economy needed more stimulus, not less.

“There were undeniable signs that the economy was slowing down,” McBride says. “It looks a lot like 2022,” but the Fed’s outlook is now different “because we’re talking about inflation that’s at a 40-year high and the urgency to bring it down.”

Interest rates approached neutral again in July 2022, when authorities raised interest rates by three-quarters of a point for the second time this year to a target range of 2.25 to 2, 5%. Still, Fed Chairman Jerome Powell noted in an August speech that neutrality is “no place to stop or take a break,” given that inflation is well above 2 % and that the labor market is extremely tight.

To complicate the debate, officials in the minutes of the Fed’s July meeting questioned whether the point at which rates would actually begin to constrain the economy was now well above 2.5%, at least in the short term. . Former Treasury Secretary Lawrence Summers has also spoken out on the subject, calling in July “inconceivable” a neutral rate of 2.5% when inflation is more than three times that amount.

“The problem with the long-term neutral rate is that no one really knows what it is,” says Megan Greene, chief global economist at the Kroll Institute. “It’s intellectually important for the Fed to raise rates above what it thinks is neutral, but another debate, besides trying to figure out where neutrality lies, is how much additional rates should go. above neutral to lower inflation.”

Why neutral debate is important for your money

Cooling inflation is currently the Fed’s main concern. The more rates have to climb to accomplish this mission, the more perilous it can be for the economy. Even Powell admitted the process can inflict some pain, suggesting officials aim to get the job done, even if it means triggering a recession.

Powell and Co. hope this will underscore for consumers the Fed’s commitment to lowering inflation. But it also means things could get worse for Americans before they get better. A bumpy road lies ahead, illustrating how important it is to prepare for tough times by building your emergency fund, staying on track with your investments, and finding the right place to keep your money during the biggest hit. to your purchasing power in four decades.

“Everything suggests that the risks of a recession over the next year are quite high,” says Friedman of MacKay Shields. “It’s hard to conceive of a soft landing when inflation is high.”

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