The neutral rate explained – and why the unknown rate matters to your money – Bankrate.com | Jewelry Dukan

The September Federal Reserve meeting is likely to usher in a new era for monetary policy, and it could be the point where things start to feel really ugly for the US economy – inherently.

With officials likely to raise rates by a three-quarter point this week, the Fed’s interest rate will cross a crucial line for the first time in more than a decade: an economic red zone known to monetary policymakers as “neutral interest.”

The threshold is illusory, even for Fed policymakers. It’s constantly moving, down almost 2 percentage points since the official estimates were first released, and is more of a guess than an absolute value.

But for consumers and businesses, the ramifications are clear: once rates rise above that point, the Fed believes rates will stop stimulating the US economy. Instead, they actively slow down activity.

In the Fed’s race to slow the economy, things could get worse before they get better

That could make Americans feel like things could get worse. Certainly many feel they have already witnessed a slowdown in the economy. The S&P 500 is down more than 19 percent year-to-date, economic activity has declined for two consecutive quarters, the once-buoyant housing market is stalling and consumers have never felt more guilty about a University of Michigan sentiment gauge, according to the financial system .

But aside from these rate-sensitive sectors, the US economy still looks good on paper. It is increasingly becoming a problem for everyone – both central bankers and consumers, who are faced with the reality that interest rates will likely have to rise much more than anyone expected before sweltering inflation abates.

Companies have almost two job openings for every unemployed person and have created almost half a million jobs on average over the last 12 months. Even with increasing announcements of layoffs in the technology and financial services sectors, Americans don’t seem to have very long to look for new jobs, and unemployment is at nearly half-century lows.

But price pressures are showing worrying signs of warming beyond expensive food and gas prices, even as the Fed hikes rates at its fastest pace in four decades. Rents, for example, rose in August at their fastest rate since August 1986, while medical supplies, college tuition, insurance, appliances and services also rose sharply.

“Outside of the housing market, there isn’t much evidence that past rate hikes are slowing the economy,” said Steve Friedman, a macroeconomist and chief executive at MacKay Shields, a former vice president of the New York Fed. “It raises the question of whether they need to push interest rates even further into the restrictive territory.”

Interest rates are rising faster than many businesses and consumers have ever seen

Technically, the Fed’s neutral interest rate is the point at which interest rates stop stimulating economic growth, but they’re also no longer constraining it. In normal times, it is intended to be a “do-no-harm” rate-setting barricade, reflecting the short-term interest rate consistent with maintaining both stable prices and full employment – the Fed’s dual mandate. Policymakers alternate on both sides of the line when they want to speed up or slow down the economy.

When the economy faces a crisis or needs a boost, officials are likely to ensure interest rates stay below that threshold. This makes money cheap, prompting consumers to spend more and giving companies the tools they need to expand, strengthening the employment side of the Fed’s mandate.

But interest rates have been in this position since the aftermath of the financial crisis – meaning consumers and businesses don’t have much time to remember the environment ahead.

When interest rates rise above neutral, the Fed specifically seeks to rein in spending, investment and hiring. They will probably do it for one reason: to cool down inflation.

“The idea of ​​neutrality is a bit muddy, but we know that inflation is way too high, the labor market is way too tight and interest rates are still too low to solve any of those problems,” says Greg McBride. CFA, Bankrate’s Chief Financial Analyst.

Where is the neutral course?

The so-called neutral interest rate is currently estimated at 2.5 percent, at least according to the Fed officials’ median estimate from their June projections. At the same time, however, the estimates range from just 2 percent to 3 percent, as shown by the Fed’s models.

It highlights the key issue: neutral is up for debate and takes into account a variety of factors including productivity, trend growth, inflation expectations and financial conditions. That’s why officials are often fond of saying that neutral is something inferred rather than known — and it’s just another factor complicating the Fed’s job.

The Fed has certainly learned that getting it right can be difficult since it began publishing its neutral estimates in January 2012. At the time, neutral was thought to be 4.3 percent. Officials gradually lowered that estimate — until June 2019, when 2.5 percent officially became the goalpost.

Interest rates in 2018 came close to the Fed’s estimate of neutral. The fed funds rate peaked at 2.25-2.5 percent after the central bank’s ninth and final rate hike in December 2018, but tepid inflation amid the lowest unemployment rate in half a century tested officials’ belief that interest rates would neither slow nor speed up the economy once they reached 2.8 percent.

Through June 2019, officials would cut interest rates at three consecutive meetings starting a month later to assess the economy needed more stimulus – not less.

“There were unmistakable signs that the economy was slowing down,” says McBride. “Sounds a lot like 2022,” but the Fed’s perspective is different now, “because we’re talking about inflation that’s at a 40-year high and the urgency to bring it down.”

Interest rates again approached near neutral in July 2022, when officials hiked rates by three-quarters of a point to a target range of 2.25 to 2.5 percent for the second time this year. Still, Fed Chair Jerome Powell noted in an August speech that neutral “is no place to stop or pause” given that inflation is well above 2 percent and the labor market is extremely tight.

To make matters worse, officials in the July Fed meeting minutes questioned whether the point at which interest rates will actually begin to constrain the economy is now much higher than 2.5 percent, at least in the short term. Former Treasury Secretary Lawrence Summers has also been vocal on the issue, calling in July a neutral interest rate of 2.5 percent “unthinkable” when inflation is more than three times higher.

“The problem with the long-term neutral rate is that nobody really knows what it is,” says Megan Greene, chief global economist at the Kroll Institute. “It’s intellectually important for the Fed to raise rates above what it thinks is neutral, but another debate besides trying to figure out where is neutral is how much more rates need to rise above neutral to keep inflation at bay to lower.”

Why neutral debate counts for your money

Cooling inflation is the Fed’s top concern right now. The higher interest rates have to rise to fulfill this mission, the more dangerous it can become for the economy. Even Powell admitted the process can cause some pain, implying that officials are only concerned with getting the job done, even if it means triggering a recession.

For consumers, Powell and co hope it underscores the Fed’s commitment to bringing inflation back down. But it also means things could get worse for Americans before they get better. A bumpy road ahead of you that shows the importance of preparing for tough times by building your emergency fund, staying on track with your investments, and finding the right place to put your money during the biggest drop in your purchasing power can keep for four decades.

“Everything indicates that the risks of a recession are quite high next year,” says Friedman of MacKay Shields. “It’s difficult to engineer a soft landing when inflation is high.”

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