Invisible and intangible, this is the biggest challenge faced by the Federal Reserve!

Since the election, U.S. stocks have soared, while the U.S. bond market has fallen into a tug-of-war between bulls and bears, with both major market participants trying to predict the direction of the U.S. economy after the Trump administration takes office.

The crux of the issue lies in a controversial topic that has troubled Federal Reserve economists and Wall Street professionals. This thing, like the so-called aliens, has never been seen, but everyone believes it exists: it is the neutral interest rate.

Kathy Jones, Chief Fixed Income Strategist at Charles Schwab, recently described the neutral interest rate as "the Bigfoot of finance."

The definition of the neutral interest rate is simple; it is the interest rate that neither stimulates nor suppresses economic growth, and it is the optimal point for balancing growth and inflation. If the interest rate is below the neutral rate, the economy may overheat; if it is too high, growth will stagnate. The problem is that no one really knows what interest rate level constitutes the true neutral rate.

Jones said, "You simulate data by looking at the past, for example, productivity might be one of the factors." She pointed out that if worker productivity increases and output rises, the economy can grow—importantly, without inflation.

Minneapolis Fed President Neel Kashkari recently expressed a similar view, explaining that "in a higher productivity environment, the neutral interest rate should be higher." He stated that if productivity structurally improves, the Fed has less room to cut rates before the economy returns to neutral.

However, this elusive rate is crucial for shaping Fed policy.

At an investment conference, Kashkari responded to comments made by Fed Chair Jerome Powell during the September FOMC press conference, stating, "The neutral interest rate is not directly observable. We understand it through its impact on the economy."

As the Fed is currently cutting rates, a higher neutral interest rate means the Fed does not need to cut rates significantly to support the economy. Conversely, a lower rate implies the need for more aggressive cuts.

Recently, investors have begun to accept the view of a higher neutral interest rate.

When the Fed began its rate-cutting cycle in September, investors expected the Fed to lower short-term rates to 2.8% by the end of 2025, or within a range of 2.75% to 3%. The bond market now anticipates that the Fed will cut rates less than four times in the next six weeks, with the federal funds rate expected to reach a range of 3.75%-4% next year.

Fortunately, Powell and his colleagues at the Fed currently seem to have some leeway.

In a speech last week at the Dallas Regional Chamber, Powell stated, "The economy has not sent any signals indicating that we need to rush to cut rates."

Jones herself prefers to carefully study actual data rather than modeling with theoretical predictions. She said, "We will observe the situation from real data and then proceed from there."