Global Search for Neutral Interest Rate to Influence Finance Costs, According to Reuters

By Howard Schneider and William Schomberg

WASHINGTON/LONDON – With major central banks now unified in their decision to cut interest rates, a real-time experiment is unfolding regarding how the global financial landscape has shifted since the pandemic. A critical question is whether this easing cycle will be short-lived due to higher underlying rates.

The Federal Reserve recently joined the European Central Bank, the Bank of England, and others in cutting rates, implementing a larger-than-expected half-point reduction. This move could have significant repercussions—analysts suggest it may have cleared the way for the People’s Bank of China to introduce its largest stimulus package since the pandemic while alleviating concerns about local currency fluctuations.

However, the duration and extent of global easing remain uncertain as policymakers assess whether the rates necessary to control inflation and sustain economic growth are higher than the historically low levels prevalent before the pandemic.

Officials in the U.S., Europe, and the U.K. are cautious in trying to pinpoint what the "neutral" interest rate might be, relying instead on observing economic conditions as rates decrease. This process is complex and requires a mix of intuition and analysis.

Despite the uncertainty, there is a consensus that the neutral rate is likely higher than it was before the pandemic, suggesting that decision-makers will likely take a more measured approach to future rate cuts as they grapple with this new reality.

Fed Chair Jerome Powell indicated that the ultra-low rate environment of the past is unlikely to return. "That world is so far away now," he stated. "It feels to me that the neutral rate is probably significantly higher than it was back then. How high is it? I just don’t think we know… We only know it by its works."

These "works" include achieving the 2% inflation target shared by major central banks, alongside maintaining low unemployment, stable wage growth, and healthy economic expansion.

Among major central banks, only the Bank of Japan is refraining from easing, opting instead to tighten its policy after successfully raising inflation.

In its recent projections, the Fed indicated a median target for rate cuts at 2.9% by the end of 2026, with estimates ranging between 2.4% and 3.9%. Fed Governor Michelle Bowman emphasized that the neutral rate has likely increased, suggesting the Fed is closer to its theoretical endpoint than previously believed.

The dynamics of data and debates surrounding it in the coming months will be crucial for determining borrowing costs for mortgages, auto loans, and business financing. In the U.S., mortgage rates that averaged around 3% during the previous decade spiked to nearly 8% during the Fed’s tightening phase, now gradually falling toward 6%. However, a recent Fed study indicated that mortgage rates may not drop below 5%.

The European Central Bank does not have a specific neutral rate estimate. Still, a recent staff paper suggested a real rate of approximately zero—or about 2% in nominal terms when adjusted for inflation—compared to a slightly negative real rate prior to the pandemic. The Bank of England does not provide a precise estimate for the neutral rate, but its latest survey indicated analysts perceive it at around 3.5%.

In August, following the BoE’s decision to lower rates to 5% for the first time since 2020, Governor Andrew Bailey echoed Powell’s sentiment, suggesting that the era of low rates is likely over. "It’s unlikely that we are going back to the world we were in between 2009 and the point at which we started raising rates," Bailey remarked, highlighting that the previous environment was shaped by significant shocks to commodity and labor markets and altered global supply dynamics.

Factors such as demographic shifts, productivity changes, and other underlying trends point toward potentially more intense price pressures and elevated interest rates moving forward, according to Jason Thomas, head of global research and investment for Carlyle.

"Central banks do not set policy in a vacuum or under self-selected circumstances," he noted. "The world has changed since 2019 in ways likely to ensure that price pressures emerge before interest rates approach levels comparable to those experienced during the pre-pandemic era."