The Federal Reserve's interest rate decision is coming! Global investors focus on the guidance of "neutral interest rate."

Central banks around the world are trying to manage the economy by setting interest rates at levels that do not encourage or hinder activities such as car purchases and construction projects. These efforts revolve around a middle number—an interest rate that neither stimulates nor pushes the economy into recession, also known as the "neutral interest rate."

This is an important guideline, as noted by the Zhitong Finance APP, because as the inflation year during the pandemic comes to an end, monetary policymakers in developed economies are lowering interest rates, but they are also being cautious in their rate cuts due to the emergence of new inflation risks. This means that the debate about the neutral interest rate will influence how long central banks will continue to lower rates.

What is the neutral interest rate?

In theory, the neutral interest rate is the rate at which monetary policy neither stimulates nor restricts economic growth. As former Federal Reserve Vice Chair Lael Brainard stated in a speech in 2018, it is the level that "keeps output growth close to potential growth rates in an environment of full employment and stable inflation."

Why is this number so important for central banks? From a long-term perspective, central banks want their policies to align with what they believe the neutral interest rate is. This number also guides their thinking about what level interest rates should be in the short term. If the economy is operating below full capacity, they want to ensure that interest rates are below the neutral level to help promote economic growth. Conversely, if inflation is too high, they want to keep interest rates above the neutral level to slow down inflation.

How does the Federal Reserve know what the neutral interest rate is?

The Federal Open Market Committee (FOMC) of the Federal Reserve does not actually know the exact figure, but there are estimates. Central bank officials tend to believe that long-term trends in productivity and demographics determine its level. In 2012, when Federal Reserve officials first began to release quarterly estimates of the neutral interest rate, the median provided by FOMC members was 4.25%. In the following years, this number declined, hovering around 2.5% from 2019 to 2023. However, in 2024, it has been rising slightly each quarter, reaching 2.875% as of September.

How do estimates of the neutral interest rate affect the Federal Reserve's actions?

The Federal Reserve wants to keep interest rates close to the neutral level for the following reasons: the U.S. economy is performing well, thus reducing the necessity for significant rate cuts. But inflation is largely under control, which also means there is little need to maintain high rates. In other words, there is no compelling reason to stimulate or restrict the economy.

Therefore, the Federal Reserve's recent strategy reflects its efforts to target the expected neutral interest rate without going below it. The Fed adopted a relatively aggressive rate-cutting approach in early autumn when rates were well above the neutral rate, implementing a larger-than-usual half-percentage-point cut in September. But now, rates are expected to reach 4.33% by the end of the year—only 1.5 percentage points above the Fed's estimated neutral rate—officials have indicated that they can slow the pace of rate cuts. Federal Reserve Chairman Jerome Powell stated at a meeting on December 4, "As we try to find the neutral interest rate, we can be a bit more cautious." How Does the Uncertainty of Neutral Interest Rates Affect Investors?

For bond market investors, the debate over where the neutral interest rate lies is becoming increasingly important. U.S. Treasury yields often follow the Federal Reserve's benchmark interest rates. If the Federal Reserve's estimate of the neutral interest rate continues to rise, officials may not further cut rates significantly, which could lead to losses for bond investments. However, if the Federal Reserve's estimate of the neutral interest rate remains below 3% and rate cuts continue, betting on bonds could yield substantial profits. Federal Reserve officials will release new estimates of the neutral interest rate in the "Economic Projections Summary," which includes the dot plot and inflation outlook, on December 18th at Eastern Time