Fed cuts interest rates again – but how low is enough?

The Fed cuts interest rates again, but how will officials know when enough is enough?

It’s a question central bankers are debating — and the answer to it could make borrowing on anything from cars to homes more expensive for years to come. The question at its core is whether the era of low interest rates following the 2008 financial crisis is over.

Fed officials are guided in part by the idea that there is an interest rate at which Fed policy has a neutral effect — not overly stimulating the economy through cheap borrowing but also not hindering it by making expensive loans. But determining this number is much more difficult.

“It’s the moderate price. It’s not too hot, it’s not too cold, it’s just the right price,” said Beth Ann Bovino, chief economist at U.S. Bank. “The problem is that no one knows what they are. They’re all estimates.”

Fed Chairman Jerome Powell said last month that the central bank was moving toward a “more neutral policy stance.” However, Fed officials have a wide range of views on what neutrality means. Their latest forecast puts the long-term neutral rate somewhere between 2.6% and 3.9%.

If the neutral rate is at the upper limit, the Fed may have limited room to cut interest rates. This is because the benchmark interest rate is already in a target range of 4% to 4.25%.

However, if the neutral interest rate is closer to 2.5%, the Fed has more room to cut rates.

The Fed’s goal, like a car approaching a stop sign, is to avoid an “annoying stop,” said Luke Tilley, chief economist at Wilmington Trust.

“What the Fed is doing now is trying to take the foot off the brake a little bit — to have a smooth transition to the point where they’re neither using the brake nor the gas,” Tilly said.

But finding this balance is not easy.

Why did the neutral rate fall?

In the years leading up to the coronavirus pandemic, the economic world was preoccupied with the gradual decline in the neutral rate, also referred to as the r-star.

Low interest rates were beneficial to borrowers because loans were cheaper, but they also indicated potential structural weaknesses and less dynamism in the economy.

“When growth prospects are strong, the growth rate tends to be higher,” Jennifer McKeown, chief global economist at Capital Economics, said in a recent webinar. “When savings are abundant or the desire to invest is weak, they tend to decline.”

Demographics were one of the reasons behind the low rates. Baby boomers are approaching retirement and have invested in less risky assets such as government bonds. Longer life spans mean more money needs to be saved. Low birth rates in major economies have led to a decline in the number of workers, weakening their growth potential. The problem with inflation was not that it was too high, but that it was too low.

The world, perhaps still reeling from the effects of the 2008 crisis, was saving more and spending less. It was an era of “secular stagnation,” as some economists called it.

Demographics and other global trends were responsible for much of the decline in interest rates between 1990 and 2019, according to a recent study from the Federal Reserve Bank of San Francisco. They added that the pace of population aging has slowed and is putting less downward pressure on interest rates.

One popular model co-developed by New York Fed President John Williams suggests that demographics and declining productivity will continue to impact the neutral rate.

“It appears that the era of low stars is far from over,” Williams said in a speech this summer, though he also noted that the concept “at the heart of critical theory” remains “puzzling to quantify.”

Surveys of market participants indicate that they believe the neutral rate is rising. The Fed’s median forecast has also risen, from about 2.5% in the past few years to 2.9% in the most recent forecast.

What has changed since Covid?

Untangling the reasons behind the potential increase and whether it will continue is a challenge.

The impact of artificial intelligence is a major debate, with some economists arguing that it could make the economy more productive and increase its potential output. There are some early signs that “an AI-driven economic boom is about to begin,” Capital Economics’ McKeown wrote in a research note.

However, President Donald Trump’s immigration policies could push the neutral rate lower, because a smaller workforce could hinder economic growth.

“This barrier should decline as future administrations take a less aggressive stance,” McKeon wrote. “But for now, that will offset the positive momentum from stronger investment in AI.”

There may be other factors causing the neutral rate to be higher. Baby boomers who have now retired have shifted into spending mode, rather than accumulating savings.

Governments are also spending more, with deficits rising to finance pension programs and strengthen defense capabilities, especially in Europe. Financial markets may charge governments higher interest rates when they borrow, perceiving a slightly higher risk that they will have difficulty repaying their debts.

If the neutral rate rises, financial crises “become a greater risk” as government interest payments swell, according to a recent study by Maurice Obstfeld, a professor at the University of California at Berkeley and former chief economist at the International Monetary Fund.

Investors have mostly ignored rising US debt levels, but they have sent more warnings to Japan, the UK and France, where financial problems have helped spark a political crisis.

The decades-long trend toward globalization appears to be changing. Disruptions during the coronavirus outbreak have prompted some companies to move their supply chains closer to home, and Trump’s tariff policies may reshape those chains further.

Inflation has fallen since its spike in 2022, but scars may linger among consumers and businesses and possibly lead to higher costs. Financial markets could also play a role, if investors demand higher interest rates to compensate for the risk of their investments being eroded by inflation.

One recent study has limited the potential effects of such factors. Each individual interpretation could lead to neutral interest rates being raised somewhat, University College London economist Lucas Rachel wrote. He found that a return to pre-2008 interest rate levels is possible. But for that to happen, he wrote, many upside risks “will likely need to crystallize at once.”