After cutting interest rates by more than one percentage point, US Federal Reserve officials are wondering what level they should stop at, and disagreements appear to be growing more pronounced than ever.
Over the past year or so, estimates of where interest rates will ultimately end have recorded the greatest divergence since at least 2012, when U.S. central bank officials began publishing their forecasts, fueling an unusually public split over whether to take another cut next week, and what will happen after that.
Federal Reserve Chairman Jerome Powell acknowledged the sharp differences of opinion within the monetary policy committee regarding which of its two goals—price stability and maximum employment—should take precedence. The crux of the matter was whether the economy needed further stimulus to support labor markets, and whether policymakers should slow the pace of stimulus given inflation's exceeding the target rate and the potential for tariffs to push it higher.
But this raises another question, albeit a more abstract one, but one of increasing importance to the whole debate: What interest rate will neither stimulate nor stifle the economy? This is the presumed endpoint of the monetary easing cycle, also known as the neutral interest rate, and Federal Reserve officials are currently having a collective struggle to determine its level.
The divergence in expectations for the neutral interest rate has increased.
The last time bank officials published their forecasts was in September, when 19 officials presented 11 different forecasts, ranging between 2.6% and 3.9%, with the latter being close to the current interest rate level.
Stephen Stanley, senior US economist at Santander, said: There is a wide divergence of opinion. There is some disagreement on this issue, but the scope of that disagreement has widened recently.
Stanley also sees the growing importance of projections, with the Federal Reserve's benchmark interest rate reaching the upper end of the range of expectations. He added, It's starting to become a potential binding constraint for some of the more hawkish Fed members. This certainly means that each subsequent cut will become increasingly difficult.
All of this is confirmed by some recent statements from central bank officials. On November 20, Philadelphia Federal Reserve President Anna Paulson explained how the twin risks of rising inflation and unemployment rates, coupled with the possibility that interest rates were already close to the neutral level, prompted her to be cautious ahead of the December meeting.
She said: Monetary policy must carefully balance the two objectives, as every interest rate cut brings us closer to the level at which policy may shift from curbing economic activity to starting to give it a boost.
Controversy over the neutral interest rate
The neutral interest rate, also known as r-star (based on the mathematical notation used to represent it in models), or the natural interest rate, cannot be directly observed but can only be inferred. It has been the subject of intense debate for over a century, with some economists, including John Maynard Keynes, questioning its fundamental usefulness. However, few contemporary central bankers agree.
This idea forms the core of monetary theory and its application, according to John Williams, president of the Federal Reserve Bank of New York and an expert on the subject. He pointed out that the failure of monetary policymakers to identify changes in natural or neutral levels of interest rates and unemployment can have serious consequences, citing the high inflation expectations of the 1960s and 1970s.
Neutral interest rates are widely seen as being driven by long-term shifts in factors such as demographics, technology, productivity, and debt burdens, all of which affect saving and investment patterns.
Trump ally at the Federal Reserve calls for interest rate cut
In addition to disagreement over the current estimates at the Federal Reserve, there is also disagreement over their direction.
Minneapolis Federal Reserve President Neel Kashkari expects that widespread adoption of artificial intelligence will lead to faster productivity growth, which will raise the neutral interest rate as demand for capital increases due to new investment opportunities.
Stephen Miran, a member of the Federal Reserve Board of Governors who was recently appointed to the central bank by President Donald Trump, indicated that current policies should also play a role in the debate.
In his first speech on monetary policy after joining the Federal Reserve, Miran argued that Trump’s tariffs, immigration restrictions, and tax cuts had all combined to lower the neutral interest rate, albeit only temporarily, so the Federal Reserve should significantly ease monetary policy to avoid damaging the economy.
For his part, Williams last month expressed doubts about allowing short-term changes to be made to estimates, noting that global trends, such as population aging, keep neutral interest rate estimates at historically low levels.
The Federal Reserve is preparing for a new administration next year.
For a decade or so before the pandemic, when inflation was low and interest rates were near zero, policymakers seemed to be almost in agreement on the neutral interest rate level, but rising prices since then, along with uncertainty surrounding trade, immigration, and the impact of artificial intelligence on the economy, have left a number of analysts wondering whether the divergence of estimates is the new normal.
Furthermore, the Federal Reserve is set to change its leadership in 2026, with Trump pledging to appoint a new president committed to lowering interest rates. The US president may have further opportunities to appoint his allies to the central bank. The new policymakers are expected to advocate for cheap money, as Miran has done, and their projections may also indicate a lower neutral interest rate in the near term.
Financial conditions continue to support the US economy.
Although the neutral interest rate is to economists what dark matter is to astronomers—something that cannot be seen directly—some monetary policymakers prefer to judge it by its results, as Powell put it.
St. Louis Federal Reserve President Alberto Musallam points out that declining default rates show that financial conditions are still supporting the economy, while his counterpart at the Cleveland Federal Reserve, Beth Hammack, said that narrowing credit spreads indicate that monetary policy is hardly tight, if ever.
However, extracting indicators from financial markets is not an easy task, as some Federal Reserve officials consider the 10-year Treasury yield, which hovers near 4%, as evidence that financial conditions are not holding back the economy, while others point out that these indicators reflect expectations about the path of the economy, along with global demand for safe assets, meaning that their usefulness is negligible when trying to estimate neutral interest rates.
Monetary policy decisions are based on actual data.
Given the considerable uncertainty surrounding the outlook, it is unlikely that the disputes over the neutral interest rate will end when Federal Reserve officials release their latest estimates next week.
At the same time, tangible factors, labor market data and price data, will drive actual monetary policy decisions, according to Patrick Harker, who served as president of the Federal Reserve Bank of Philadelphia until his retirement this year.
Harker said the neutral interest rate is a useful analytical tool, but only a tool. It doesn't guide monetary policy decisions. He added, I can't recall a single instance where everyone was gathered, and the entire conversation revolved around the question: What is the neutral interest rate?
