Key Takeaways
- The Federal Reserve’s decision on whether to cut interest rates again depends heavily on the uncertain “neutral rate,” the level at which policy neither slows nor stimulates the economy.
- With rates now at 3.5% to 3.75% after multiple cuts, Fed officials disagree on whether policy is still restrictive or already near neutral, fueling debate over next steps.
- Persistent inflation, shifting global dynamics, and unknown effects from artificial intelligence are complicating estimates of the neutral rate.
Investopedia Answers
The debate over whether the Federal Reserve may cut interest rates again soon rests partly on a number that no one knows: the neutral rate of interest.
It’s the rate at which the Fed has a neutral impact on the economy—neither restraining growth with high interest rates nor stimulating it with cheap borrowing. The Fed hasn’t been there in years, having slashed rates to near-zero during COVID, then hiked them above 5% when inflation spiked.
Today, rates are closer to more normal levels. After six rate cuts in 2024 and 2025, the Fed’s benchmark rate is now between 3.5% to 3.75%. But how close the Fed is to neutral—or whether it’s already there—will help determine whether the central bank may cut rates again.
The uncertainty over that number may make the Fed a bit more careful in the meantime, so it doesn’t inadvertently push below the neutral rate and rekindle inflation with unnecessary stimulus.
Why This Matters
How close the Fed is to its neutral rate will influence whether borrowing costs fall again or stay higher for longer. For consumers, investors, and borrowers, that decision affects mortgages, loans, and market expectations.
“The Fed always moves more cautiously when rates are close to a neutral setting,” wrote Michael Pearce, chief U.S. economist at Oxford Economics.
It’s a debate that’s set to continue after President Donald Trump’s nominee for Fed chair, Kevin Warsh, joins the central bank.
The current Fed chair, Jerome Powell, spoke directly on the uncertainty at his press conference last month. His message: rates aren’t so high that the economy is weakening significantly, but beyond that, it’s difficult to say.
“It’s hard to look at the incoming data and say that policy’s significantly restrictive at this time,” Powell said. “It may be sort of loosely neutral, or it may be somewhat restrictive; it’s in the eye of the beholder. And of course, no one knows with any precision.”
After three cuts last year, he said, the Fed is “well-positioned here to watch how the economy forms” and “let the data speak to us.”
Has it Gone Up or Down?
One big debate among economists right now is whether the neutral rate has risen from its pre-pandemic levels—which would make borrowing more expensive for years to come.
The years between 2008 and 2020 were abnormal in many economists’ view. Despite interest rates being at ultra-low levels, the crisis-scarred economy never gained much steam. Inflation was mostly below the Fed’s 2% target—prices were so stubbornly subdued that it suggested structural weaknesses in the economy.
Demographics were one culprit, as an aging population in the United States and elsewhere saved for retirement—holding down interest rates worldwide.
“The current era has been characterized by much lower neutral interest rates, disinflationary pressures, and slower growth,” Powell said in a 2019 speech.
Now inflation is closer to 3% and may be stickier than in recent memory, which could drive up interest rates to compensate for rising prices. Global supply chains are being reworked, whether from post-COVID shifts or tariffs, and the impact on prices is uncertain.
Even more unclear is whether artificial intelligence will lower or raise interest rates. Perhaps it’ll make the economy far more productive, but it could also pose major disruptions to the job market.
“There is still much to learn,” Fed Vice Chair Philip Jefferson said in a speech last year. “I counsel exercising humility about the challenges in predicting AI’s effects on employment and inflation.”
What is clear is that the Fed’s forecasts for the neutral rate have gone up in recent years. At the end of 2019, the median Fed official thought it was 2.5%. Now, their median forecast has risen to 3.0%. That could give Fed officials an earlier stopping point for rate cuts before hitting neutral.
Fed officials, however, have a broad range of forecasts for neutral—anywhere from 2.6% to 3.9%. It’s why Powell says the Fed’s current rate is “within the range of plausible estimates” of neutral.
Restrictive vs. Accommodative
Three words are critical to understanding the debate in the months ahead: restrictive, neutral and accommodative.
When demand is too hot and inflation is rising, the Fed aims to restrict the economy and sets interest rates above neutral. If the economy is faltering, the Fed gives it an extra push with lower interest rates and thus accommodates for growth.
But since Fed officials define neutral differently, they also split on when they’ve struck the right balance.
Take St. Louis Fed President Alberto Musalem. Last month, he said he supports keeping rates at between 3.5% to 3.75% since “this setting is neutral” and thus appropriate for an economy that seems on track.
“With inflation above target and the risks to the outlook evenly balanced, I believe it would be unadvisable to lower the rate into accommodative territory at this time,” Musalem said, though he added he’d support cutting “if further signs of labor market weakness emerge.”
By contrast, Atlanta Fed President Raphael Bostic said this month the neutral is perhaps one or two rate cuts away. But he also said he didn’t pencil in any rate cuts for this year, since the economy’s current strength raises the risk of inflation persisting.
“I think we have so much momentum in the economy that we need to keep our policy rate in a mildly restrictive stance,” Bostic said, adding that “this is a time to be patient.”
And still others think the economy is a bit weaker—thus calling for less restrictiveness. Fed Governor Chris Waller, who voted in the minority to cut rates last month, said last year’s jobs data was “very weak.”
Despite three rate cuts last year, Fed policy is “still restricting economic activity” and rates “should be closer to neutral.” He pointed to Fed officials’ median neutral estimate of 3%, still below the current Fed benchmark rate of 3.5% to 3.75%.
“I favored reducing the policy rate to strengthen the labor market and guard against a deterioration that would be harder to address once it has begun,” Waller said.