What is neutral monetary policy?
Your question is quite relevant to monetary policy today. In a sentence,
a so-called “neutral” monetary policy, also called the “natural” or “equilibrium” rate,
is the federal funds rate rate that neither stimulates (speeds up, like
pushing down the gas pedal on a car) nor restrains (slows down, like
hitting the brakes) economic growth. What does this mean?
What is the federal funds rate?
You may know that the federal funds rate is the interest rate that banks
charge each other for overnight loans. It also is the interest rate that
the Federal Open Market Committee (FOMC) targets when it meets eight
times each year to make monetary policy decisions, which are designed
to achieve the Federal Reserve’s goals of maximum employment, stable
prices, and moderate long-term interest rates.
How does the fed funds rate compare to other interest rates?
Though the FOMC sets only short-term rates, movements in the federal
funds rate are a benchmark for many other interest rates in the economy.
As shown in Chart 1, most interest rates tend to move fairly closely
in line with the fed funds rate. This is because the FOMC’s decision
to raise or lower interest rates may act as a signal to financial markets
about the health of the economy, concerns about inflation expectations,
or both—thus changes in the overnight interest rate may affect
changes in longer term securities. Still, it is important to remember
that the Fed is only able to directly influence the federal funds rate,
a short-term interest rate.
Chart 1 –Interest rates have
tended to move together over time
The Neutral Rate
At what rate or range of rates does a change in the federal funds rate
go from being low enough to be “accommodative” to being high
enough to dampen economic activity? The answer is the neutral rate, often
defined as the rate or range of rates consistent with full employment,
trend growth, and stable prices. An economy in this state presumably
wouldn’t need to be stimulated or slowed by monetary policy.
neutral rate is often explained using the story of Goldilocks searching
the home of the three bears; as Janet Yellen, president and CEO of
the Federal Reserve Bank of San Francisco, recently observed in an interview
in The International Economy Magazine, “monetary policy
should be at neutral only when economic conditions are ‘just
How is the neutral fed funds rate calculated?
Defining the neutral rate proves to be much simpler than calculating
it, as noted by Federal Reserve Bank of San Francisco Economist John
C. Williams in his October 2003 Economic Letter, “The Natural Rate
of Interest.” The neutral federal funds rate has no explicit
value—it is an estimate,
and as economists famously disagree on many issues, they can also disagree
on the range in which the neutral rate falls, and how it might change
Economists often describe the neutral rate by talking about the real federal funds rate— that is, the nominal fed funds rate minus a measure of inflation (such
as the Personal Consumption Expenditures Price Index). Chart 2 displays
both the real and nominal rates for recent decades. Calculating the real
fed funds rate allows you to look at changes in interest rates in terms
of purchasing power, or without the effects of changes in inflation.
For additional information on the difference between nominal and real
interest rates, see the August
2003 Dr. Econ.
Chart 2 – The nominal and real fed funds rate
What is the neutral rate in 2005?
In her interview with The International Economy Magazine Dr. Yellen
also noted estimates of the neutral ranges of both real and nominal fed
“Research suggests that the neutral real rate is probably somewhere
in a 1.5 percent to 3.5 percent range. To get to a neutral nominal
rate, we have to add in expected inflation. That probably takes us
to a neutral
nominal range of around 3.5 percent to 5.5 percent at this point.”
In addition, most economists agree that the neutral rate is not constant
over time. Just as economic conditions are constantly changing, so does
the monetary policy direction at a given time that would be consistent
with neutrality. The factors that determine the neutral range are complicated
and varying; as Dr. Yellen further noted in the same interview:
“The neutral real rate itself depends on a variety of factors – the
stance of fiscal policy, the trend of the global economy which shows
up in our net exports, the level of housing prices, the equity markets,
the slope of the yield curve, or the term premium built into the
yield curve. So it changes over time.”
A chart created by San Francisco Fed Economist Glenn Rudebusch from
the April 2004
edition of FedViews,
San Francisco Fed’s online forecast, provides a nice illustration
of how the neutral rate may have changed over the period from 1989 to
April 2004. As the chart’s title indicates, monetary policy was
considered quite accommodative in April 2004; the federal funds target
rate was set at one percent, far below the estimated neutral range.
Chart 3 - One estimate of the neutral rate over time
How close are we today to being “neutral”?
On June 30, 2004, the FOMC voted to raise the fed funds rate by 25 basis
points to 1-1/4 percent —after holding it at 1 percent for a year.
At each successive FOMC meeting (at least up to the August 2005 publication
date) the FOMC continued to raise rates by 25 basis points. You may have
noticed that the FOMC statements released
after each of these FOMC meetings stated, “the stance
of monetary policy remains accommodative.” Over much of the year,
the Committee has also indicated that accommodation can be removed at
a pace that is “likely to be measured.”
Though many economists estimate that U.S. monetary policy is currently
near the neutral range, Fed Chairman Alan Greenspan has acknowledged
how challenging it is to know where the neutral rate truly lies:
“It’s very difficult to know where that so-called neutral
rate is. But we probably will know it when we are there because we
will observe a certain degree of balance, which we had not perceived
which would suggest that we are somewhere very close to where that
“Essentially you get down to the point that we will not know
it until we're actually there.”
For more information on how open market operations effect the federal
funds rate and the economy, please see the chapter, “How the Fed
Guides Monetary Policy,” in the Federal Reserve Bank of San Francisco’s
2005 publication, “The Federal Reserve System in Brief.”
For additional discussion
on the relationship between discount rate and mortgage rates, see Ask
Dr. Econ, June 2002.
“The Yellen View.” The
International Economy Magazine (Spring 2005).
Fedviews is not
archived. Only current month is available.
additional discussion on how the neutral rate might be calculated, see Williams (2003).
Rates Will Rise at ‘Measured Pace,’” Financial
Advisor News, June 9, 2005.
aid U.S. as thought,” MSNBC.com,
May 20, 2005.
Reserve System in Brief." 2005. Federal Reserve Bank of San
“U.S. Monetary Policy: An Introduction.” 2004. Federal
Reserve Bank of San Francisco.
Reserve Bank of San Francisco.
Williams, John C. 2003. “The Natural Rate of Interest.” Federal
Reserve Bank of San Francisco, Economic Letter. Number 2003-32,
October 31, 2003.
Rates Will Rise at ‘Measured Pace’”,
Financial Advisor News, June 9, 2005.
won’t aid U.S. as thought,” MSNBC.com,
May 20, 2005.