The Federal Reserve’s “Neutral Rate”

Federal Reserve officials raised interest rates for the second time this year on June 12 and upgraded their forecast to four total increases in 2018, as unemployment falls and inflation overshoots their target faster than previously projected. The increase has moved the target the target rate to 2% from 1.75%. The Fed announcement also referred to the neutral rate of 2.9%

Source: The Federal Reserve Bank of Atlanta

The neutral rate for Fed Funds refers to the rate that is viewed by the Fed as being neither expansionary nor constraining to the economy and is based on productivity, economic growth and inflation. This equilibrium rate will rise as the economy and productivity improve or as inflation rises, which it often does hand in hand with an expanding economy.

What is important from our point-of-view is that the equilibrium measure used in this chart the “Taylor Rule Prescription” now stands at 3.3%, up from 2.9% and has been rising from 2010 while the Fed has kept an expansionary policy in place since the recession of 2008. They are now attempting to bring their policy rate into alignment with what they perceive to be an equilibrium rate. Thus the call for another two rate hikes in 2018 and four more in 2019.