The Fed has just cut interest rates again – and the timing is undeniably awkward

Fed officials emphasize that their decisions depend on economic data, firm indications of the economy’s health and possible direction. But there is one key concept that governs the Fed, which Chairman Jerome Powell says is “theoretical” and “not directly observable.”

This is the so-called “neutral interest rate”, an interest rate level that neither stimulates nor dampens the economy. The Fed’s main tool is its key interest rate, which affects the cost of borrowing across the economy, and it works by either increasing demand if interest rates are low or by cooling it if interest rates are high. It depends on whether the Fed is dealing with high inflation, which causes the Fed to slow the economy, or high unemployment, which forces the Fed to do the opposite.

Economists describe the neutral interest rate as theoretical because it depends on many, many factors that make it too imprecise – such as population growth, productivity, saving behavior, any structural changes in the economy and so on, in addition to the effects of borrowing costs.

With inflation significantly down from a four-decade peak reached in 2022, and just a whisper away from the Fed’s 2% target, the Fed has shifted more attention to the US labor market, which has weakened steadily over the past few years. It remains in good shape, but Powell telegraphed in September that the Fed is committed to maintaining its strength and avoiding any deterioration.

Fed officials have said they believe borrowing costs are still at restrictively high levels, putting the labor market at risk. Now it’s a question of how quickly the Fed wants interest rates to go back to the neutral rate. Of course, it also depends on inflation. Some officials have said they don’t feel there is an urgency to cut rates.

“I’m in no rush to get to neutral,” Atlanta Fed President Raphael Bostic said last month at an event in Jackson, Mississippi. “We need to get inflation back to our 2% target, and I don’t want us to get to a place where inflation stalls because we haven’t been restrictive long enough. So I’m going to be patient.”