Neutral Interest Rate

What Is the Neutral Rate?

The neutral interest rate (often written as r* or "r-star") is the short-term real interest rate consistent with the economy running at full capacity without accelerating or decelerating inflation. It is a theoretical benchmark: if the policy rate is above r*, policy is restrictive; below r*, policy is stimulative.

Why It Matters for Markets

Every rate decision the Fed makes is implicitly judged against r*. When the Fed raised rates from 0% to 5.25–5.5% in 2022–2023, the crucial question was whether the neutral rate had risen from its post-GFC level of ~0.5% real. If r* had risen to 1.5–2% real (implying a nominal neutral of ~3.5–4%), the Fed was only mildly restrictive. If r* was still 0.5%, the Fed was very restrictive.

How r* Is Estimated

r* cannot be directly observed — it must be estimated using econometric models. The NY Fed's Laubach-Williams model and Holston-Laubach-Williams model are the standard references. Both are highly uncertain with wide confidence intervals. Fed Chair Powell has described r* as "flickering light that is always receding."

The Post-Pandemic Debate

After COVID, several factors may have permanently raised r*:

• Larger fiscal deficits requiring higher rates to attract bond buyers
• Deglobalisation reducing deflationary pressure
• Energy transition capex crowding out private investment

If r* has risen, what looks like restrictive policy is actually neutral — meaning less tightening has occurred than headline rates suggest.

Trading Implications

When markets price in rate cuts, they are really pricing in a move back toward r*. If r* is higher than assumed, rate cuts will be fewer and shallower — a hawkish surprise. If r* is lower, rate cuts can be deeper — a dovish surprise.