Neutral Interest Rates

When central banks started cutting interest rates to near zero after the 2008 stock market crash, they saw it as an emergency measure and thought things would gradually get back to normal. Ten years later, they’re wondering what normal means. For the past decade, rates have been super-low, and many economists came to believe they’d stay that way. They argued that the so-called normal or neutral rate of interest — which neither stimulates the economy nor cools it down — had fallen, perhaps permanently. But now the debate is shifting again. Central banks are moving to tighten policy by raising interest rates, while steady growth and fresh economic stimulus from tax cuts and public spending are leading some to believe that the neutral rate is creeping back up. The implications for savers, investors and economic-policy makers will be far-reaching.

The possibility that the neutral rate is rising is influencing the Fed’s current thinking on monetary policy. The Fed’s long-term projection of its policy rate is inching higher. It was 2.8 percent at the end of 2017; it now stands at 3 percent. As the policy rate rises, Fed officials are emphasizing that estimates of the neutral rate — where rates might end up — are inherently uncertain. Until recently, interest rates had been heading lower for years. Average interest rates in 20 developed nations dropped from about 5 percent in 1990 to near zero in 2015, a Bank of England study found. Such low rates left central banks little or no room to cut again if more stimulus was required. The U.S., Europe and Japan used new tools to stimulate economic growth, from quantitative easing (buying government bonds in exchange for new money) to negative rates (pushing interest rates below zero). The policies weren’t as effective as central banks hoped, and fears grew that this wasn’t just a temporary problem. Since well before the crash, the world had settled into a pattern of investing less and saving more. The result was a global surplus of capital, and in turn a lower neutral rate of interest. While those long-term factors haven’t gone away, the view that the neutral rate is stuck is starting to shift.