At the FOMC meeting in July, Fed Chairman Powell mentioned the following during the press Q&A session, “The federal funds rate is at a restrictive level now. So if we see inflation coming down credibly, sustainably, then we don’t need to be at a restrictive level anymore. We can move back to a neutral level and then below a neutral level at a certain point.”

What does a “restrictive level” of interest rate mean? What about a “neutral level”? In this month’s featured chart, we take a closer look at the natural rate of interest and related data to examine how monitoring whether the interest rate in the U.S. has reached a sufficiently restrictive level can help us assess if the rate hike cycle is nearing its end.

1. The Natural Rate of Interest, the Long-Term Policy Rate Anchor

To gauge the Fed’s monetary policy stance, we should first understand the concept of the natural rate of interest. Sometimes known as the neutral interest rate, the natural rate of interest is the real interest rate (calculated by subtracting the inflation rate from the nominal interest rate) that keeps economic output at its potential level, while maintaining stable inflation. This natural rate serves as an anchor for real interest rates over the long term where the long-term aggregate supply and demand is in equilibrium.

To put it simply, the natural rate is the real interest rate that enables economic growth at an optimal pace, without overheating or sliding in recession, while keeping inflation in line with the 2% target. In reality, when the real interest rate approaches to the natural rate, monetary policy stance is said to be relatively neutral, neither stimulating nor contracting the economy.

Looking at the natural rate estimates published by the New York Federal Reserve Bank based on the Holston-Laubach-Williams (HLW) model, we can see that, influenced by slowing productivity growth and the effects of an aging population, the neutral rate has been on a downward trend since 1970, declining from 5% to around 1%. And it has remained stable at the lower level over the past decade, even after the COVID-19 pandemic.

Yet in reality, the interest rate does not remain at a neutral level but fluctuate as monetary policy changes. In the next section, we explain how comparing these rates can inform whether monetary policy stance is restrictive or accommodative.

2. Identifying Policy Shift: What Exactly Does a Restrictive Level Imply?

The natural rate is a key reference for gauging monetary policy stance. Since the natural rate refers to the real interest rate at long-term equilibrium, we should look beyond the nominal interest rate when assessing policy stance. That is, we should compare the natural rate with the real interest rate, which is nominal interest rate minus inflation rate (represented by the annual growth rate of the PCE Price Index):

Restrictive range: Real federal funds rate > Natural rate of interest
Non-restrictive range: Real federal funds rate < Natural rate of interest

In a typical rate hike cycle, when the real interest rate approaches the neutral rate, as indicated by the yellow bars inching closer to the zero axis in the chart, it means monetary policy has become restrictive enough to curb inflation, which can also serve as a signal that we’re getting close to the terminal rate, the central bank’s desired level of policy tightening.

Takeaway from MacroMicro

As shown in the chart, since the start of the rate hike cycle in 2022 Q1, the Fed’s policy has shifted from extremely accommodative to tightening. In 2023 Q1, interest rates entered the restrictive range, with the real interest rate surpassing the natural rate of interest (the yellow bars inching to the positive territory in terms of quarterly averages).

At the current level of inflation, the real federal funds rate stands at 2.1%. Based on the Fed’s June Summary of Economic Projections (SEP), which projects inflation to be around 3.2% at the end of 2023, a simple calculation would show that, even without further rate hikes, the real federal funds rate is already restrictive enough compared to the neutral interest rate of around 1%.

Therefore, if inflation continues to ease, there is little room for substantial rate hikes moving forward. Looking ahead, we can monitor progression of the indicators in the chart for clues to potential policy shifts.

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