New Federal Reserve News Agency: Has the era of ultra-low interest rates at the Federal Reserve come to an end?

On Wednesday, the Federal Reserve lowered interest rates as expected but signaled a pause in rate cuts. Jerome Powell also stated that we are now significantly closer to the neutral interest rate. How far the U.S. is from the neutral interest rate will be the core issue determining the future direction of Federal Reserve policy, and the higher neutral rate forecast in the post-pandemic era also signifies the end of the ultra-low interest rate era.

In a recent article, Wall Street Journal reporter and "New Federal Reserve News Agency" Nick Timiraos pointed out that Powell's remarks on the neutral interest rate raised a previously unimportant but now critical question: What exactly is "neutral" in the post-pandemic economy?

The neutral interest rate refers to the level of interest rates that exists when the economy is at full employment and inflation is stable. This rate cannot be directly observed but is inferred from economic conditions. If borrowing and consumption are strong, price pressures rise, and the current interest rate may be below the neutral rate. Conversely, if borrowing and consumption are weak and inflation declines, the interest rate may be above the neutral rate.

Earlier this year, the debate over the level of the neutral interest rate was not particularly significant, as nearly all Federal Reserve officials believed that rates were at restrictive levels. But now this issue has become a focal point, as the Federal Reserve has lowered rates by a full percentage point, and the economy appears to be in good shape.

Timiraos noted that just as a captain tries to avoid crashing into the dock as the ship approaches the slip, if the central bank governor believes they may be closer to their final destination due to rising neutral rates, they may become more cautious when cutting rates.

Powell stated on Wednesday, "We don't know exactly where it is, but... we can be sure that we are now 100 basis points closer to it... From now on, this is a new phase, and we will be cautious about further rate cuts."

The neutral interest rate may be much higher than pre-pandemic levels

After the 2008 financial crisis, economists and Federal Reserve policymakers steadily lowered their estimates of the neutral interest rate. Years of ultra-low rates and monetary stimulus did not provide much boost to the economy, and some economists believe that low rates will persist due to demographic headwinds from an aging workforce and long-term insufficient new investment demand.

However, post-pandemic, as a series of fiscal stimulus measures brought the economy back to a new equilibrium, the neutral interest rate has risen in recent years. Over the past year, Federal Reserve officials have gradually increased their estimates of the neutral interest rate.

Timiraos stated that Federal Reserve officials predict long-term interest rate levels each quarter, which effectively serves as their estimate of the neutral interest rate. The median forecast dropped from 4.25% in 2012 to 2.5% in 2019, remaining at that level until 2023.

However, the neutral interest rate has steadily risen in all four quarterly forecasts this year—the latest forecast released on Wednesday is 3%, with 8 out of 19 officials estimating it to be above 3%, whereas in June 2023, only two officials believed the neutral interest rate was above 3%. Following the latest rate cut, the current benchmark federal funds rate is around 4.3%

If the neutral interest rate has risen, the Federal Reserve may pause rate cuts for a considerable time

Timiraos stated that Powell is skeptical about using precise estimates of the neutral interest rate to guide policy, believing that officials can only understand the neutral rate by observing its impact on the economy.

Jon Foster, a former senior advisor to Powell, pointed out that the result of this is that even if the neutral interest rate has risen, the Federal Reserve may not be able to obtain clear evidence in a timely manner to adjust policy. He believes the neutral interest rate could be between 2.5% and 4%.

In fact, prior to the recent rate cut decisions, some Federal Reserve officials expressed concerns about further rate cuts based on the potentially inaccurate concept of the neutral interest rate.

Dallas Federal Reserve President Lorie Logan warned that excessive rate cuts could lead to a resurgence of inflation, forcing the Federal Reserve to raise rates. She emphasized that recent data suggests the neutral interest rate may have risen and is close to the current federal funds rate level.

Timiraos' article noted that the economy remains strong despite rising interest rates, which may simply reflect some temporary factors, such as increased immigration or businesses and households locking in low rates during the pandemic. However, over time, if the economy continues to grow, policymakers may begin to believe that the economy has entered a new normal with a higher neutral interest rate.

Jason Thomas, chief economist at private equity firm Carlyle Group, believes that the increase in labor productivity indicates that the economy is different from the situation in the decade following the global financial crisis. In the coming years, investors and central bankers may recognize that higher rates are not just a result of the Federal Reserve's rapid rate hikes, but a reflection of broader structural forces.

Thomas stated, if officials conclude that the neutral interest rate has risen, then the Federal Reserve may pause rate cuts for a considerable time.