What Are ‘Neutral’ and ‘Terminal’ Interest Rates?

Central banks seek to manage economies by setting interest rates at levels that encourage (low rates) or discourage (high rates) things like car purchases and construction projects. These efforts revolve around a number that’s right in the middle — the rate that does nothing at all, also known as the neutral interest rate. It’s an important guidepost right now because most monetary policymakers are still trying to set rates high enough to bring down inflation — but not so high as to guarantee an economic recession. That means the debate over the neutral rate will influence at what point this tightening cycle hits its peak, at what’s known as the terminal rate.

1. What is the neutral interest rate?

In theory, the neutral interest rate — or, as it’s usually written down in economic models, r*, pronounced “r-star” — is the rate at which monetary policy is neither stimulating nor restricting economic growth. As former Fed Vice Chair Lael Brainard put it in a 2018 speech, it’s the level that “keeps output growing around its potential rate in an environment of full employment and stable inflation.” (The benchmark the Fed uses to direct monetary policy is known as the federal funds rate.)

2. Why is it an important number?

In the long run, central banks want their policy to be consistent with what they think the neutral rate is. The number also guides their thinking about where interest rates should be in the short term. If the economy is operating below full capacity, they want to make sure interest rates are below neutral levels so that they’re helping boost economic growth. Conversely, if inflation is too high, they want to keep interest rates above neutral levels in order to slow things down.

3. How does the Fed know what the neutral rate is?

It doesn’t know for sure, but it has estimates. Central banks tend to think that long-run trends in productivity and demographics dictate where it is. In 2012, when Fed officials first began publishing their estimates of the neutral rate on a quarterly basis, the median Federal Open Market Committee participant pegged it at 4.25%. Over the ensuing years, that estimate was continually marked down; in June it was 2.5%.

4. What do Fed officials say?

Even if Fed officials think 2.5% is a neutral level for interest rates in the long run, they’re not betting the farm on that. They know they’re dealing with unusual circumstances, including the pandemic-induced disruption of supply chains and the shock waves from Russia’s invasion of Ukraine. New York Fed President John Williams said in May that the pandemic’s impact on the neutral rate “appears to be relatively modest,” while Cleveland Fed President Loretta Mester said in early July that it was too early to know whether the long-run neutral rate had moved. “Honestly, we don’t know” where the neutral rate is, Fed Chair Jerome Powell told lawmakers in March.

5. How has that been received?

Whether a 2.5% federal funds rate can be considered neutral or too low has led to some spirited debate. Former Treasury Secretary Lawrence Summers said last year it was “indefensible” to have such a low neutral rate, while Jason Furman, who led the Council of Economic Advisers in President Barack Obama’s White House, said it wasn’t too low. Recently there has been speculation that r* is moving higher.

6. How do estimates of neutral change what the Fed does?

That’s not entirely clear. Fed officials have been raising rates quickly since March 2022 in a bid to bring inflation under control. In July, policymakers decided to raise the target range for the federal funds rate to 5.25-5.5%, the highest level in 22 years. They have emphasized that while rates are at or near restrictive territory — high enough to slow the economy — inflation hasn’t slowed as quickly as they would like. In June, nearly all officials forecast that the federal funds rate would need to go higher. Eventually, once inflation comes back down — the consumer price index excluding food and energy posted its smallest back-to-back gains over the last two months since 2021 — the Fed may try to navigate back to the neutral rate.

7. What about the terminal rate?

When Fed officials published their quarterly projections in June, the median estimate by FOMC participants had the funds rate peaking at 5.6% in 2023, before returning to 4.6% in 2024 and 3.4% by late 2025. By contrast, the terminal rate during the bout of high inflation that started in the 1970s was 20% — and produced one of the century’s deepest recessions. Fed officials who want to avoid a repeat are hoping that holding rates steady at levels well above neutral over the next few years will do the trick.