The Federal Reserve meets next week to again determine what interest rates are needed to keep inflation in check while the economy continues to grow, with the goal being to return to normal economic conditions, although the calculation depends on how “normal” is defined and what interest rates would be in a normal, booming economy.
You want moderate inflation and GDP growing at just the right rate — steady and not overheating. The interest rate that keeps all of this in balance is called the natural or neutral interest rate.
“The neutral rate is kind of a guide for the Fed,” said Matthew Paniati, senior analyst at Capital Advisors Group.
In other words, if you're sailing north, the currents and winds may force you to steer east or west, but your compass will help you get back on track. The same is true with the Federal Reserve.
“Over the longer term, it's possible that short-term rates will stray from the neutral rate for the Fed, but over the longer term, that's where the Fed wants to go,” Paniati said.
Sometimes inflation spikes and the Fed has to slow the economy down, or the economy stagnates and the Fed has to stimulate the economy.
“And when they need to slow the economy, they raise interest rates above the natural rate; when they want to speed up the economy, they lower interest rates below the natural rate,” said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics.
There's one problem with this North Star, this shining interest rate on a hill: You can't measure interest rates directly, Gagnon said. It's theoretical, and there's no easy formula that can reveal it.
“But over time, you look back and you can see roughly where it is,” he said.
But wait, if we look back and the economy was stable, would the primary interest rate have been appropriate at the time?
Maybe so, according to David Rogal, a fixed-income portfolio manager at BlackRock Inc. “The margin of error in these models is very wide because the neutral rate is unobservable,” he says.
Currently, the Fed believes that the neutral interest rate is 2.5%, which is much lower than the 5.5% they currently use as a benchmark, so one day once all the inflation has subsided, interest rates will likely return to 2.5%, which will impact new mortgages, car loans, and credit cards.
“But I think what the Fed's announcement tells us is that there's low uncertainty on that front,” Rogal said.
The mysterious Goldilocks neutral interest rate can change depending on many factors, including population growth, productivity, and federal spending. And it may be changing now.
“I think there's a lot of good evidence that stocks are rising,” Capital Advisors' Paniati said.
First, interest rates have remained high for over a year, yet the economy has barely faltered — there has been no recession or slowdown, but inflation has remained subdued.
So the “normal” interest rates the Fed dreams of may actually be higher than they used to be — but they may not be.
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