Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Rethinking the Neutral Rate This Summer
Transcript
- Lucas: The Federal Reserve has a number it watches more closely than the unemployment rate or even core PCE in the current environment. It's called r-star — the neutral rate of interest. And the latest estimate from the New York Fed suggests it might be higher than most policymakers assumed even six months ago. Luna: We talk about the fed funds rate being at 3.63 percent, but whether that's restrictive or not depends entirely on where r-star sits. If the neutral rate has moved up, suddenly the Fed isn't as tight as it thinks. Lucas: Exactly. R-star is the theoretical rate that neither stimulates nor restrains the economy. For years after 2008, the consensus was that r-star had fallen to near zero — the so-called secular stagnation view. But data coming out this summer is challenging that narrative. Luna: What data specifically? The ten-year yield has jumped to 4.68 percent, but the breakeven inflation rate actually fell to 2.26 percent. That suggests the move in nominal yields is about real rates. Lucas: Right, real rates are rising. And that's one signal the New York Fed uses in its dynamic stochastic general equilibrium model to estimate r-star. Their latest reading, which came out earlier this month, put the real neutral rate around 1.2 percent. That's up from roughly 0.8 percent a year ago. Luna: One point two percent real. If you add the 2.26 percent breakeven, that implies a nominal neutral rate near 3.5 percent. We're at 3.63 percent. So we might be barely restrictive. Lucas: That's the takeaway. And it explains why some FOMC participants have been reluctant to signal cuts. In the June dot plot, the median longer-run fed funds rate — effectively their estimate of nominal r-star — ticked up to 3.1 percent from 2.9 percent in March. Not a huge move, but directionally important. Luna: Where is the upward pressure on r-star coming from? Is it the fiscal side? The AI investment boom? Lucas: Both. The Congressional Budget Office just revised up its deficit projections, and the fiscal 2026 deficit is running at over seven percent of GDP. That's a huge demand for loanable funds. Meanwhile, private sector investment in data centers and AI infrastructure is at levels we haven't seen since the dot-com era. Luna: And don't forget the tariff story. Import prices from China hit their highest since 2008 last month. That effectively raises the cost of capital goods and could boost the marginal product of capital, pushing r-star up. Lucas: Good point. The global backdrop matters too. Singapore's surprise tightening today is a reminder that central banks abroad are still fighting inflation. That can spill over into higher global real rates. Luna: So if r-star really is higher, what does that mean for the Fed's next move? They've been on hold since March — the fed funds rate hasn't changed. Lucas: It means the hurdle for cutting rates is higher. The Fed needs to see actual economic weakness, not just inflation coming down, because the neutral rate itself might be pulling up the floor. Chairman Kevin Warsh's recent speeches have emphasized 'data dependence' and 'patience.' That's code for: we're not convinced we're tight enough. Luna: And yet the CPI headline fell to 332.6 from 334 in May. Core CPI barely budged. PCE, though, ticked up in May. The narrative is mixed. Lucas: That's the crux. The Fed prefers PCE, and core PCE rose to 130.1 from 129.67. Services inflation is sticky. If the neutral rate is higher, then the current rate isn't delivering enough restraint to bring services inflation down sustainably. Luna: So the market pricing for a cut this year might be optimistic. If r-star is 1.2 percent real, the current real fed funds rate is about 1.37 percent — pretty close to neutral. Not much policy headroom. Lucas: Exactly. The real fed funds rate — that's the effective rate minus breakeven inflation — is around 1.37 percent. If neutral is 1.2, that's only about 17 basis points of restrictiveness. That's practically nothing. Luna: We should step back. The neutral rate concept is inherently unobservable. How confident is the Fed in these estimates? Lucas: Not very. The New York Fed's own estimates have wide confidence intervals. The current reading of 1.2 percent could be anywhere from negative to over two percent. But the direction is what matters. Multiple models — the Laubach-Williams, the holston laubach williams — all show an upward drift since late 2025. Luna: That's compelling. And it might justify the higher long-run fed funds rate in the dot plot. If the economy can handle a higher neutral rate, the Fed doesn't need to cut as much. Lucas: Right. And that has big implications for asset prices. Stocks have rallied to new highs — the S&P 500 is at 7,412, the Dow above 51,900. But long bond yields are up too. The market is pricing higher for longer. If the Fed eventually confirms a higher r-star, that narrative gets cemented. Luna: One thing that stands out: the ten-year breakeven is falling while nominal yields rise. That's a real rate rise, which is consistent with a higher r-star. It's not an inflation scare. Lucas: And that's actually reassuring for the inflation hawks. It means the bond market trusts the Fed's commitment to price stability. The term premium is also widening, which suggests investors want compensation for holding long-term debt amid fiscal uncertainty. Luna: Look, I know following r-star can feel like astronomers arguing about a black hole. But understanding that the neutral rate might have moved up changes everything about where we think the economy is in the cycle. Lucas: It does. And if today's episode helped make that concept a little clearer, hey, we love that. The way this show stays ad-free and independent is through listener support. If you found value in this, consider a small contribution at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash fexingo. Luna: Yeah, it genuinely keeps the lights on and lets us keep drilling into the stuff that matters — no sponsors, no outside agendas. Lucas: Absolutely. So back to the neutral rate question — we're not the only ones talking about this. Former Treasury Secretary Larry Summers has been arguing that the neutral rate is structurally higher due to fiscal deficits and investment demand. If he's right, the Fed may have to revise its estimates up further at the September meeting. Luna: That would be a big deal. It would mean that the 'lower for longer' era is truly over. The fed funds rate might settle around three and a half percent, not two and a half. Lucas: And that's the debate we'll be watching. So far, the data is pointing in one direction. We'll see if the FOMC formalizes it in the September dot plot. Luna: For now, it's a powerful lens for viewing every economic release. CPI, PCE, employment — they all get measured against this new, higher baseline. Lucas: Exactly. Thanks for listening. We'll be back with the next episode soon.