Chasing neutral

Stephen Stanley | September 5, 2025

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The FOMC is clearly divided on the near-term outlook for policy.  At least two governors, Bowman and Waller, wanted to cut at the July meeting.  Several others, including Chair Powell as of his August 22 Jackson Hole speech, have joined them.  However, there are a number of officials that have continued to push back, arguing that the Fed should continue to be patient.  One driver of this debate that has not gotten much public discussion lately is a range of opinion regarding what rate level constitutes a neutral policy stance.

What is neutral?

The first step in this discussion is to define what Fed officials mean when they talk about policy being neutral, restrictive or accommodative.  A neutral policy stance is the rate level that over a long period of time would neither stimulate nor drag down the economy.  If you can imagine an economy not impacted by any shocks, there is a unique policy setting that would be consistent with an economy achieving but not exceeding its maximum sustainable GDP growth rate.  That is a neutral policy stance.

Anything easier than that would be labeled accommodative.  In our theoretical world where the economy has a well-defined long-term growth rate and no shocks, if the economy starts in equilibrium—that is, the economy is already at full employment—an accommodative policy stance would cause the economy to accelerate and would ultimately lead to overheating and rising inflation.

Conversely, for that same economy operating in equilibrium, if the Fed runs a restrictive policy, any rate setting above neutral, the economy would eventually slow excessively, creating slack in the labor market or pushing inflation below target.

Of course, the real world is far more complicated than a simple theoretical model.  Neutral is not directly observable.  Policymakers and financial market participants must guess about the level of neutrality.  Chair Powell has often used a biblical allusion, indicating that “we know it by its works.”  That is, policymakers can infer the location of neutrality by carefully observing how the economy responds at various interest rate levels.  If the economy is surging in the absence of other stimuli, that would be strong evidence of accommodative monetary policy, and vice versa.

Where is neutral?

One place to start is to consult a basic model.  A methodology that I leaned on in my younger days used historical experience to draw out long-run averages in key economic variables.  Those averages would run from the 1960s, when the Fed first started using the federal funds rate as a policy tool, through the mid-2000s, a period that included periods of notably easy policy in the late 1960s and 1970s and tight policy i the 1980s.  Another key attribute of this stretch is that inflation was running at roughly the same pace at the beginning and the end of the period.  All of this offers some tentative evidence that monetary policy was on average reasonably close to neutral over the entire period.

As it happens, over that period another empirical finding that has some degree of intuitiveness is that 10-year Treasury yields averaged close to the mean pace of nominal GDP growth.  This relationship makes sense at a very high level, as the interest rate that clears the investment-savings equation for the economy should be pretty close to the pace at which the economy expands over time.

We can then get to a neutral policy stance by noting that the average spread over that long time period between 10-year Treasury yields and the fed funds rate was about 50 bp.

Applying this framework to the current situation, most economists would peg the equilibrium real growth rate for the economy at close to 2%, although the FOMC puts it at 1.8%, and the Fed’s inflation target is 2%.  So, nominal GDP growth and thus the 10-year Treasury yield should be in the neighborhood of 4%, which would put the neutral fed funds rate somewhere close to 3.5%.

That framework appeared to break down in the wake of the financial crisis, when interest rates remained historically low for years on end.  Various models used to estimate the equilibrium real interest rate for the economy were spitting out close to zero or even negative figures.

Many Fed officials and most financial market participants came to view the super low interest rate regime as the new normal.  The median longer-run dot in quarterly Fed rate projections, a reasonable proxy for estimates of neutrality, dropped to as low as 2.5% and stayed there for years.  Consider that in early 2022, just before the Fed began to raise rates off of the zero bound after the pandemic, fed funds and SOFR futures indicated that financial market participants thought that the FOMC would never be able to raise rates above 2% without sparking a recession.

However, the FOMC ended up having to push the funds rate target above 5% to bring inflation down.  And yet, rather than inducing a recession, as most had predicted, the restrictive policy stance coincided with an extended period of above-trend growth and robust labor market conditions in 2023 and 2024.

On the back of this development, Federal Reserve officials’ assessment of the longer-run neutral policy stance drifted higher, as the median dot ascended to 3%, where it has held since December 2024.

A range of opinion

As noted above, the median longer-run FOMC dot projection shows that the consensus view on the committee is that neutral sits close to 3%.  However, that median estimate belies a fair amount of disagreement.  In June, of the 19 longer-run dots, there were three fairly distinct groups.  There were four dots at 2.50% or 2.625%, the low neutral camp.  There were eight dots between 2.875% and 3.125%.  And then there were seven dots in the high neutral camp, ranging from 3.375% to 3.875%.

Fed officials’ public comments offer guidance on who is in each camp.  For example, I would guess that New York Fed President Williams is in the low neutral group.  He did extensive academic research years ago as a Fed board staffer on models that estimate neutrality, and he recently noted that a model that he developed along with two colleagues shows that for the U.S. as well as Canada, the EU, and the UK, estimates of equilibrium interest rates are around 0.5% in real terms, not far from pre-pandemic readings.  Williams stated that “based on this evidence, the era of low r-star appears far from over” (r* is the academic symbol for the neutral policy rate in real terms).

In contrast, several Fed Bank presidents have argued that the sustained vigor of the economy over the past few years in the face of interest rate levels that have generally been viewed as substantially restrictive requires a new look at the location of neutrality.  For example, last month, Kansas City Fed President Schmid laid out his case for a higher neutral estimate:

“How much is the current stance of policy restricting the economy? My assessment is not very much. As I said, we are as close to meeting our dual mandate objectives of price stability and full employment as we have been for quite some time. And while uncertainties abound, I do not see strong evidence of a trend movement away from our mandates at this point. This all suggests to me that the stance of monetary policy is not far from neutral. More generally, looking at financial markets, with stock prices near record highs and bond spreads near record lows, I see little evidence of a highly restrictive monetary policy.”

Neutrality and the policy debate

The range of views on the location of neutrality are in my view playing a vital but not well understood role in the policy debate.  This is a particularly difficult period for the Fed, as inflation remains well above its 2% target and may be pushed even higher in the near term by tariff-related price hikes, while economic growth and the pace of job creation have slowed.  In any episode like that, when the Fed’s two dual mandate goals appear to be moving into conflict, it is reasonable to expect differences of opinion about how policy should respond.  Some officials tend to nearly always lean to the hawkish side, putting more weight on the inflation target, while others tend to lean dovishly, putting greater emphasis on supporting the labor market and the economy.

In the current landscape, there is an additional complication, as policymakers do not even agree about the current stance of policy.  For those who see a neutral policy rate at 3% or lower, the current setting of 4.375% is substantially restrictive, giving the Fed ample room to cut without fear of overstimulating the economy.  Governor Waller laid out this view in his recent speech titled “Let’s Get On with It.”  While he offered a dovish emphasis on downside risks to the labor market, he also referenced his perception that policy is currently restrictive:

“My eagerness to move now is supported by my view that monetary policy is moderately restrictive. In June, the median of FOMC participants estimated that the longer-run value of the federal funds rate, akin to what it would be now without restricting or stimulating the economy, is 3 percent. With the target for the federal funds rate in a range of 4.25 percent to 4.5 percent, that means we are 1-1/4 to 1-1/2 percentage points above neutral.”

One can understand his perspective.  If the current policy stance is restrictive by close to 150 basis points, then the Fed can easily cut rates by 25 bp or 50 bp without any risk of going too far, since even the lower policy rate would still be well in restrictive territory.  Given that degree of margin as well as the fact that Waller sees danger signs in recent labor market data, he is inclined to cut quickly and relatively aggressively.

As noted above, there will always be different views for any given array of economic data.  Where Governor Waller sees downside risks in the labor market data, President Schmid argued on August 12 that “while it is true that payroll growth was weak over the summer, a broader set of indicators suggest a labor market that is in balance.  The unemployment rate remains low, wage growth remains solid, and the ratio of reported job vacancies to available unemployed workers is about one-to-one, a matching that suggests a labor market close to balance.”  Thus, there would be differences, even if everyone agreed about the location of neutrality.

Indeed, St. Louis Fed President Musalem noted on Wednesday that, even assuming that the neutral rate is 3%, the median FOMC participant estimate, “multiple Taylor rule specifications currently prescribe a policy rate around today’s level of the federal funds rate and above estimates of the long-run neutral rate,” given that the unemployment rate signals full employment while inflation remains well above the Fed’s 2% target.

Nevertheless, the assessment of neutrality also matters.  Cleveland Fed President Hammack laid out the importance of her sense of the current policy stance on how the Fed should act going forward when she argued back in June:

“In my view, the current policy stance is only modestly restrictive: the labor market has been healthy, and inflation has come down only slowly under the current setting. This feels to me like policy is already close to neutral. Given the resilience of the economy thus far, the risks from maintaining the current policy setting appear low, and I don’t see a weakening in the economy that would merit imminent rate cuts, though I remain attentive to that possibility. Looking ahead, if both sides of our mandate come under pressure, then holding the policy rate steady for some time may be the best choice to balance the risks coming from further elevated inflation and a slowing labor market.”

In contrast to Governor Waller, President Hammack and her more hawkish colleagues believe that the Fed has little margin to play with, since the current policy stance is quite close to their assessment of neutrality.  Thus, unlike Waller, they see significant risk in cutting rates more than marginally.

Conclusion

There will always be hawks and doves on the FOMC, and at a time when the two dual mandate goals appear at risk of being in conflict going forward, one would expect a heightened degree of divergence of views on the committee.  However, an additional complicating factor is the wide range of opinion regarding the neutral setting for policy and thus how restrictive the current policy setting is.  This debate is likely to continue to rage in the months ahead.