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What is a "neutral" interest rate?

Mitchell Hartman Nov 29, 2018
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Federal Reserve Chairman Jerome Powell speaks at the Economic Club of New York on November 28, 2018 in New York City. Following news that Powell said interest rates are close to neutral, stocks rose in afternoon trading.
Spencer Platt/Getty Images

Fed Chairman Jerome Powell helped spark a stock market rally when he said interest rates were “just below” neutral at the Economic Club of New York yesterday. Many market observers saw this as an indication that the central bank won’t raise interest rates as many times next year. But what does a neutral interest rate mean?

Basically, the Fed tries to manage the economy by setting a key interest rate, the “federal funds rate,” which helps determine how much it costs to borrow money to buy a house or expand a business. The Fed lowers interest rates when it wants to encourage borrowing and stimulate the economy. It raises rates to slow the economy down. 

Syracuse economist, Donald Dutkowsky, says the Fed’s always trying to hit the economy’s sweet spot: “neutral”.

“So it doesn’t need stimulus and it doesn’t need slowing down. A neutral federal funds rate corresponds to the economy being at full recovery,” he explains.

Right now, the federal funds rate is 2 to 2-and-a-quarter percent. Ken Matheny at Macroeconomic Advisers predicts a few more rate hikes over the coming year, to reach what he thinks is the Fed’s current “neutral” target, around 3 percent.

“Then that creates some room for it to cut rates in the future if it needs to do so to provide stimulus,” Matheny says. 

In a briefing on Fed interest-rate policy published on Nov. 28 Matheny wrote,

We continue to anticipate that above-trend growth will contribute to even tighter labor markets and that core inflation will rise slightly above 2% on a sustained basis in response to tight labor markets, rising (non-energy) input costs, tariffs, and perceptions of more pricing power by businesses.  Consistent with our forecasts for growth, labor markets, and inflation, we continue to anticipate a rate hike next month, followed by 3 rate hikes in 2019 and 1 more in 2020 that will bring the upper end of the target range for the federal funds rate eventually to 3½%.  That is ¾ percentage point above our assumption of the long-run neutral rate.

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