Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Care About the Neutral Rate
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- Lucas: So, we keep hearing that the Federal Reserve is 'close to neutral' — but what does that actually mean? It sounds like a mystical point on a map that nobody can see. Luna: It's a bit like the horizon — you can point to it, but you never quite get there. And as of August 2026, the debate over where 'neutral' sits is the single most important argument in markets. Lucas: Right. The neutral rate of interest, sometimes called r-star, is the rate that neither stimulates nor restrains the economy — the Goldilocks level. If the policy rate is below r-star, the Fed is pushing on the accelerator. If it's above, it's tapping the brakes. Luna: And the tricky part is, you can't observe it directly. You have to infer it from the data. That's like trying to figure out the wind speed by watching how much the trees bend. Lucas: Exactly. And that inference problem has real consequences. After the aggressive hiking cycle in 2022 and 2023, the Fed held rates at a twenty-year high for over a year. Then they started cutting in late 2024. By mid-2026, they've eased a bit, but the big question is: how far can they go before they hit the neutral floor? Luna: And that's where the estimates get personal. Some economists think r-star is still around zero point five percent in real terms. Others, like a camp that's been gaining influence, argue it's closer to one point five or even two percent. Lucas: So let's unpack that. The long-run neutral rate, the one that anchors policy in the future, is driven by productivity, demographics, and global savings and investment flows. For a long time, the consensus was that r-star had fallen — the famous secular stagnation thesis. But after the pandemic, a few things shifted. Luna: You're talking about the rise in productivity, right? Lucas: Yeah. Artificial intelligence and faster digitization may have lifted potential growth. At the same time, big budget deficits and defense spending have raised investment demand. And then there's the retirement wave — the boomers are shifting from savers to spenders, which reduces the supply of savings. Luna: So the old r-star, the one that said two percent nominal rates were the new normal, might be stale. Lucas: That's the crux. If r-star has risen by even half a percentage point, then the current policy rate may be more restrictive than it looks. That would mean the Fed could cut more aggressively without reigniting inflation. Luna: But if r-star is still as low as before, then today's rates are closer to neutral, and the Fed has less room to ease. That's why every data release — CPI, employment, anything — gets parsed for clues. Lucas: And the Fed itself has been vague. Their dot plot shows committee members' guesses, but there's a wide dispersion. In June 2026, the median projection for the long-run policy rate was around three percent, but the range went from two point five to three point five. Luna: That half a percentage point range sounds small, but it's huge for markets. It changes the terminal rate, the valuation of every bond, every stock, every piece of real estate. Lucas: One way to pin down r-star is to look at real interest rates — the nominal rate minus expected inflation. If you strip out inflation, what's the real cost of borrowing? Historically, that's been around one percent in the US. But recently, some estimates put it at one point eight, maybe two percent. Luna: Which is a big deal because if the real neutral rate is two percent, then the Fed's current nominal policy rate of, say, three point two five percent implies a real rate of around one point seven five percent — that's actually below neutral, meaning the Fed is already stimulating the economy. Lucas: And that's exactly the kind of argument that's fueling the debate. Some economists say the Fed has already done enough easing, maybe even too much. Others say they're still restrictive because the real rate is above the long-run r-star. Luna: So how do you actually measure r-star? Is there a formula? Lucas: There are several models. The most famous is the Laubach-Williams model from the New York Fed. It uses a statistical filter to extract trends from growth, unemployment, and inflation. But the model's estimates are notoriously uncertain — the confidence intervals are huge. Luna: And those intervals get even wider in real time, because the data gets revised. The model's real-time estimate can shift a lot from one quarter to the next. Lucas: Right. And that's why central bankers rely on more than just one model. They look at market-based measures like the five-year, five-year forward rate, which is a bet on future real yields. They also look at surveys of primary dealers and economists. Luna: But those measures are also influenced by term premia and risk sentiment, right? So they're not a pure read on r-star either. Lucas: Exactly. So you triangulate. And the current triangulation suggests that r-star has probably moved up from the post-2008 era, but by how much is contested. Some, like former Treasury Secretary Larry Summers, have revised their views. He used to argue for secular stagnation, now he says the era of ultra-low rates may be over. Luna: What about the international perspective? Is this only a US story? Lucas: No, it's global. The euro area, Japan, the UK — all central banks are grappling with the same question. But the factors vary. Europe has weaker productivity growth, Japan has different demographic pressures. So r-star isn't the same everywhere. Luna: And it changes over time. Right now, the market's expectation of where the Fed funds rate will be in five years is around three percent. That's a market-based estimate of the long-run neutral rate, assuming inflation settles at two percent. Lucas: That's a nice number to hold onto: three percent nominal, maybe one percent real. But that's not carved in stone. A productivity boom from AI could push it higher. Or a global savings glut could push it back down. Luna: So the neutral rate is more like a cloud that you're constantly trying to pin down, rather than a fixed point. Lucas: And the stakes are high. If the Fed cuts too much because it thinks r-star is high, it could let inflation re-accelerate. If it cuts too little because it thinks r-star is low, it could choke off growth. Luna: Given that uncertainty, how does the Fed actually communicate its thinking? They don't just say 'we're guessing,' right? Lucas: They release the dot plot, but they've also introduced the concept of 'policy stance' in their statements. They say things like 'the stance of monetary policy is restrictive' or 'less restrictive.' That's a subtle way of signaling their own r-star estimate without giving a specific number. Luna: But investors are always trying to reverse-engineer it. Every speech, every press conference is parsed for clues about how far they think they are from neutral. Lucas: And that's why the opening of this conversation matters. In 2026, the Fed has already cut rates several times from the peak. The question is whether the next few cuts are 'insurance' or 'stimulus.' That hinges on r-star. Luna: So if we had to put a number on it today, what would you say? Real r-star in the US is somewhere between zero and two percent? Lucas: I'd say the honest answer is somewhere around one percent, but the range of plausible values is wide. And that's okay — as long as policymakers and markets acknowledge the uncertainty instead of pretending they know the exact number. Luna: You know, this kind of conversation is exactly why we love doing this show — the subject is deep, but we try to make it accessible. And we're glad you're along for the ride. Lucas: And speaking of the ride, we've kept this show free of ads from day one. If you find these explanations useful, and you want to support that choice, you can find us at buy me a coffee dot com slash fexingo. It's a small way to keep us going. Luna: Absolutely. No pressure, but if you feel like it, that link is there. We'll get back to the economics now. Lucas: So, given all this, what should an investor or a business owner do with the idea of a shifting r-star? The practical takeaway is that the old playbook of 'low rates forever' is not reliable. Luna: Meaning, don't borrow long-term assuming rates will stay at historical lows — because the neutral rate might be structurally higher. Lucas: Right. And for fixed-income investors, it means the yield curve might be steeper than it looks, because term premia are also back. The ten-year Treasury yield is not just a reflection of expected short-term rates; it includes a premium for uncertainty about r-star. Luna: So the next time you hear 'the Fed is close to neutral,' you can ask: which estimate are you using? Lucas: And that's the kind of question that makes for smarter financial decisions. Because in the end, the neutral rate is not a law of nature — it's a conditional forecast that shifts with the economy.