The neutral interest rate, also known as the “natural rate of interest” or “r-star” (r*), represents the real (inflation-adjusted) short-term interest rate that is consistent with a stable economy operating at its full potential.

At this rate, monetary policy neither stimulates nor restrains economic growth.

This rate isn’t directly observable and must be estimated through various economic models.

Think of the neural rate like a unicorn or the Minotaur, the number is mythical.

What Is the Neutral Interest Rate?

The neutral interest rate is the sweet spot where the economy is running smoothly. It’s the rate at which monetary policy doesn’t push the economy forward or hold it back.

Think of it like cruise control on a car: when the interest rate matches the neutral rate, the economy is moving steadily without speeding up or slowing down unnecessarily.

It serves as a benchmark for central banks, such as the Federal Reserve, to gauge whether their monetary policy stance is expansionary, neutral, or contractionary.

Key characteristics of the neutral rate include:

  • Non-observability: The neutral rate can’t be directly observed and must be estimated through economic models.
  • Dependence on economic fundamentals: Factors such as productivity growth, demographic trends, and global savings and investment patterns influence the neutral rate.
  • Dynamic nature: The neutral rate changes over time as economic conditions evolve.

Importance in Monetary Policy

Central banks use the neutral rate as a guide for setting interest rates to achieve their mandates, which often include full employment and price stability.

When the policy interest rate is:

  • Below the neutral rate, monetary policy is accommodative, encouraging borrowing and investment to stimulate economic activity.
  • Equal to the neutral rate, monetary policy is neutral, maintaining stable economic conditions.
  • Above the neutral rate, monetary policy is restrictive, aimed at slowing down economic growth to combat inflation.

By assessing the neutral rate, central banks can better determine the appropriate stance of monetary policy and make informed decisions about interest rate adjustments.

For example, if the Federal Reserve sets the federal funds rate below the neutral rate, the policy stance is considered accommodative, potentially stimulating economic activity.

Conversely, setting the rate above the neutral rate implies a restrictive stance, which could slow down the economy.

Accurate estimates of the neutral rate help the Fed determine appropriate interest rate levels to achieve its dual mandate of maximum employment and price stability.

How Do Central Banks Estimate the Neutral Rate?

Here’s the tricky part: no one knows the exact neutral rate.

It’s not a number you can measure directly, so economists make their best guesses using long-term trends like productivity and population growth.

These estimates are regularly updated as conditions change. In 2012, the Federal Reserve estimated the neutral rate to be around 4.25%.

Over the years, that number has dropped, staying near 2.5% from 2019 to 2023.

Over recent decades, estimates suggest that the neutral rate has declined globally. This trend is attributed to factors such as slower productivity growth, aging populations, and higher global savings rates.

To estimate the neutral rate, economists rely on methods such as:

  • Statistical filtering models, which separate short-term fluctuations from long-term trends in interest rates and output.
  • Structural models, which incorporate economic theories about the relationships between savings, investment, and growth.

How Does the Neutral Rate Affect Central Bank Decisions?

A central bank tries to steer interest rates toward the neutral rate.

Here’s how that works in practice in the U.S.:

  1. If rates are well above the neutral rate, the Fed may cut them to prevent slowing the economy too much.
  2. If rates are well below the neutral rate, the Fed might raise them to avoid overheating the economy and causing inflation.

If the U.S. economy is currently in a good place, where inflation is mostly under control, and growth is steady. That means there’s no urgent need to raise or lower rates dramatically.

Challenges and Criticisms of the Neutral Rate

Estimating the neutral rate is fraught with challenges. These include:

  • Uncertainty in Estimation: Since the neutral rate cannot be observed directly, estimates rely on complex models that incorporate productivity, demographics, and other variables. These models often yield differing results, making it hard to pinpoint the exact neutral rate.
  • Dynamic Nature: The neutral rate is not static; it changes with economic conditions, technological advancements, and global financial trends. This fluidity adds another layer of complexity to policy decisions.
  • Risk of Miscalculation: If central banks misjudge the neutral rate, they risk setting policies that either overstimulate the economy (leading to inflation) or overly restrict it (causing unnecessary slowdowns).
  • Global Influences: In a highly interconnected global economy, factors like international trade, foreign investment, and geopolitical events can affect the neutral rate, making domestic estimates less reliable.

Despite these challenges, the concept of the neutral rate remains central to monetary policy. It provides a framework for understanding the delicate balance needed to maintain economic stability.

Why Forex Traders Should Care?

The neutral rate isn’t just for economists and central bankers — it’s also a critical concept for forex traders. Here’s why:

Impact on Currency Values

Interest rates heavily influence currency values. If a central bank is cutting rates to approach the neutral rate, the currency might weaken.

Conversely, if rates are rising above neutral, the currency could strengthen. Understanding where the neutral rate is helps traders anticipate these moves.

Policy Signals

By monitoring statements from central banks about the neutral rate, traders can gauge future monetary policy.

For instance, if a central bank hints that rates are far below neutral, it may signal upcoming rate hikes, which could strengthen the currency.

Risk Management

Forex markets are influenced by interest rate differentials between countries.

Knowing the neutral rate helps traders understand these differentials and manage risks in their portfolios.

In short, keeping an eye on the neutral rate can help forex traders make more informed decisions about when to enter or exit the market, and how to position themselves for future central bank actions.

Why Should You Care IRL?

Understanding the neutral rate helps demystify why interest rates go up or down and how those changes affect your life.

When rates are close to neutral, borrowing costs for things like mortgages and car loans are generally stable. But if rates move far away from neutral, you might see big changes in loan costs, savings rates, and even job opportunities.

By keeping an eye on the neutral rate, central banks aim to strike a balance that benefits everyone: stable prices, steady jobs, and sustainable growth.