Fed faces its most serious disagreement over the neutral rate in more than a decade as the December decision approaches!

After the Federal Reserve cut interest rates by more than one percentage point, it is now facing the most severe disagreement about the neutral interest rate since 2012—a debate that is influencing this month's policy direction.

At the September FOMC meeting, 19 officials gave 11 different valuations for the neutral rate, ranging from 2.6% to 3.9%—the latter being close to the current interest rate level. This dispute over exactly where the "neutral rate" lies essentially reflects a fundamental split among decision-makers over whether the economy needs more stimulus.

Federal Reserve Chair Jerome Powell has acknowledged that the rate-setting committee faces "strong differences" in prioritizing price stability versus maximizing employment. The central question is: Does the economy need more impetus to support the labor market, or should the brakes be applied because inflation is above target and tariffs might further push up prices?

This division is turning into a rare public debate: Should rates be cut again next week, and what action should be taken thereafter? The neutral rate—the rate that neither stimulates nor restricts the economy—is seen as the end of the rate-cutting cycle, but the Fed is currently struggling to find this target position.

As the benchmark rate approaches the upper bound of the neutral rate estimation range, every rate cut decision becomes more difficult. On November 20, Philadelphia Fed President Anna Paulson stated that the dual risks of inflation and unemployment, coupled with the possibility that rates are already close to neutral, made her cautious heading into the December meeting.

The Disagreement Hits Historic Levels

Fed officials’ estimates of the neutral rate have seen the greatest divergence in the past year since forecasts began being published in 2012. Stephen Stanley, Chief U.S. Economist at Santander Bank, said:

"Our staff opinions are all over the place. While there’s always some degree of divergence, the current range is wider."

Stanley believes that these estimates are becoming especially important as the Fed's benchmark rate reaches the top of the estimation range.

"For some of the more hawkish Fed members, it can begin to act as a binding constraint," he said, "This definitely means that each successive rate cut is going to become increasingly difficult."

Explaining her cautious stance, Philadelphia Fed President Paulson noted: "Monetary policy has to walk a fine line. Every rate cut brings us closer to the point where policy shifts from slightly restraining economic activity to actually boosting it."

The neutral rate is also known as r-star, based on its symbol in mathematical models, or the natural rate. This concept cannot be directly observed and can only be inferred, sparking intense debate for more than a century. Although some economists, including Keynes, have doubted its real usefulness, few modern central bankers share that view.

New York Fed President John Williams, an expert in this field, believes the concept is "at the core of monetary theory and practice." Williams points out that failure to diagnose changes in the natural or neutral rate and unemployment rate can have profound consequences, citing surges in inflation expectations in the 1960s and 1970s as examples.

The neutral rate is generally considered to be driven by long-term factors such as demographics, technology, productivity, and debt burdens, which affect patterns of saving and investment.

Because the neutral rate is like "dark matter" to economists—unobservable directly—some decision-makers prefer, in Powell's words, to "judge by its effects."

St. Louis Fed President Alberto Musalem said that low default rates show financial conditions continue to support the economy. Cleveland Fed President Beth Hammack pointed out that narrowing credit spreads mean monetary policy is "at most barely restrictive."

However, extracting clues from financial markets is not easy. Some Fed officials view the 10-year Treasury yield lingering around 4% as evidence that financial conditions aren't holding the economy back. Others argue these indicators reflect expectations for the economic outlook and strong global demand for safe assets, so they're not very useful for estimating the neutral rate.

No Consensus on the Future Direction of the Neutral Rate

Besides lacking agreement on the current level of the neutral rate, there is also division within the Fed about its future trajectory.

Minneapolis Fed President Neel Kashkari predicts that widespread adoption of artificial intelligence will bring faster productivity growth, and as new investment opportunities boost demand for capital, the neutral rate will rise.

Fed Governor Stephen Miran, Trump’s latest appointee to the central bank, believes current policies should also be part of the discussion. In his first policy speech at the Fed, Miran argued that Trump’s tariffs, immigration restrictions, and tax cuts collectively push the neutral rate lower, even if only temporarily—thus the Fed should loosen policy significantly to avoid harming the economy.

Last month, Williams expressed skepticism about including short-term changes in the calculation. He argued that global trends like population aging are keeping rate estimates at historically low levels.

Real Data Remains the Foundation of Decisions

Given the very uncertain outlook, when Fed officials publish their latest estimates next week, the split around the neutral rate is not likely to disappear.

Patrick Harker, who retired this year as Philadelphia Fed President, said that more specific factors—"labor market data and price data"—will drive actual policy decisions. Harker said:

"The neutral rate is a useful conceptual tool, but it's just a tool; it doesn't drive policy decisions. I don't recall any occasion where we all sat down and the whole discussion was about what r-star is."

Additionally, the Fed is set for a leadership turnover in 2026, with Trump vowing to pick a new Chair committed to lowering rates, and possibly more allies appointed at the Fed. It is expected that new decision-makers will, like Miran, advocate for more accommodative monetary policy and may estimate the current neutral rate to be lower.

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