What is the neutral interest rate and why is it in focus?

With the World Economic Forum’s latest Chief Economists Outlook saying policymakers face persistent headwinds, continued volatility and slow global economic activity, central bankers around the world are grappling to find appropriate policy settings.

On top of that, they’re also seeking the neutral or natural rate of interest – the elusive rate at which the economy operates at full employment and capacity and a steady rate of inflation. It is the rate at which the economy is neither stimulated nor slowed down.

This neutral rate has long been a topic of debate and blog posts.

It’s not a directly observable figure and comes from informed estimates. It also depends on various factors that are up for debate – including GDP growth, future growth, demographics, and other variables that change over time. That’s why there’s a range of estimates among economists.

“You won’t find the neutral rate quoted on your computer screen or in the financial section of the newspaper,” former Dallas Fed President Robert S. Kaplan wrote in a blog post. “The neutral rate is an “inferred” rate – that is, it is estimated based on various analyses and observations.”

Expectations for high inflation rates have been pared back across all regions this year, compared with 2023, according to the 2024 Chief Economists Outlook. The easing of inflationary pressures means that central banks are likely to stop raising rates and may even begin to lower them.

Knowing the neutral rate is important because it helps central bankers assess whether their monetary policy is accommodative, neutral, or restrictive. This helps them use one of their key tools – interest rates – to restrict or boost activity.

If policy rates are below the neutral rate, policy is stimulatory and conversely, rates above neutral make policy contractionary.

Getting these levels right is key for price stability – with many central banks having a 2% inflation target and/or an employment goal.

A 2% inflation target is held by many, including the US Federal Reserve, the European Central Bank, the Bank of England, and the Reserve Bank of New Zealand, as being key to achieving price stability, and that underpins a well-functioning economy.

Supporters of the 2% inflation target say it helps to anchor inflation expectations, maintain price stability and keep the economy on track. However, others have questioned how useful it is, saying the target is inflexible against a backdrop of wider changes in the labour market and global trade. Meanwhile, some say it can cause central banks to fixate too much on inflation instead of other economic indicators.

The level of debate around both the 2% target and the neutral rate reflects how complex the challenge is and how many different trade-offs there are.

Many economists say that neutral rates around the world have been pushed down by structural factors like populations getting older, productivity slowing and savings rates rising.

Federal Reserve officials talk about the rate quite frequently in a bid to increase understanding of the complicated decisions they are making. But even their officials have differing views.

While estimates vary, there is general agreement that the real – after inflation – neutral rate or “R-star” rate decreased from 1960 to 2020.

A lower neutral rate comes with monetary policy challenges, as it limits the ability to cut rates in a recession.

“Despite its inherent uncertainties, I believe that the neutral rate concept is a useful tool,” says Kaplan, who was president and CEO of the Federal Reserve Bank of Dallas between 2015 and 2021. “However, because it has limitations, it is best used in conjunction with a broad range of other economic analyses as well as extensive conversations with private sector leaders and a focus on identifying and differentiating between cyclical and structural drivers of the US and global economies.”

What’s clear is that the neutral rate concept is here to stay, and will continue to exert influence over central bank decisions and spark debate.

Getting a handle on this elusive rate remains a core challenge for policymakers, just one of the many they face in 2024.